Developed Countries

Highlights Duration: The Fed will ignore inflation for the time being and focus on its “maximum employment” target to decide when to lift rates off the zero bound. As a result, bond investors should also ignore inflation and focus on the employment data. We anticipate that significant positive nonfarm payroll surprises will start in late-summer/early-fall and that they will catalyze a move higher in bond yields. Keep portfolio duration below benchmark. Fed Operations: We see no implications for the Fed’s balance sheet or interest rate policies stemming from the recent uptick in ON RRP usage. It is possible that the Fed will decide to slightly increase the IOER or ON RRP rates at this month’s FOMC meeting in an effort to move the funds rate closer to the middle of its target range, but we don’t view this as a pressing need. Inflation: Inflation will moderate in the coming months, but 12-month core inflation will remain close to or above the Fed’s target at least through the end of 2022. Baffling Bond Market Strength We’ve received more questions than usual in recent days, mostly from readers seeking to understand why long-dated bond yields fell during a week that saw one of the strongest CPI prints of the past 40 years and the Treasury dump $38 billion of new 10-year supply on the market. We believe we can explain the conundrum. First, consensus expectations are finally starting to catch up with the pace of economic recovery. Economic surprise indexes measure the strength of economic data relative to consensus expectations and they have fallen a lot compared to the elevated levels seen last year (Chart 1). In fact, if it weren’t for incredibly strong inflation data these indexes would be much closer to “negative surprise” territory. The Industrial Sector and Labor Market components of the Bloomberg Economic Surprise Index have already dipped well below the zero line (Chart 1, bottom panel). Encouragingly, the fall in surprise indexes has more to do with investor expectations ratcheting higher than it does with a slowdown in the pace of economic growth, or at least that is the message you get from the CRB/Gold ratio, an excellent coincident indicator for bond yields (Chart 2). The CRB Raw Industrials commodity price index serves as a proxy for global economic growth and it remains in a solid uptrend. What has changed in the past few weeks is that gold is also staging a rally (Chart 2, bottom panel). This tells us that bond yields are not falling because of a slowdown in economic growth. Rather, they are falling because investors see the Federal Reserve turning increasingly dovish. Chart 1Surprise Indexes Chart 2CRB/Gold Ratio Why might investors have this impression of Fed Policy? During the past few months the Fed has successfully convinced markets that it will not lift rates until its “maximum employment” target is achieved, irrespective of what happens with inflation or inflation expectations (more on this in the section titled “A Checklist For Liftoff” below). This explains why bond investors are ignoring positive inflation surprises and focusing instead on the employment data, which have been disappointing. Nonfarm payroll growth came in significantly below consensus expectations in both May and April (Table 1). In light of those disappointing numbers, investors have pushed out expectations for the timing of Fed liftoff and bond yields have fallen as a result. Table 1Monthly Nonfarm Payroll Results Versus Consensus In For A Jolt Chart 3Labor Demand Is Not The Problem We view the recent drop in yields as a bond market over-reaction to weak employment data. Investors are focusing on the weaker-than-expected nonfarm payroll numbers but ignoring skyrocketing indicators of labor demand such as the JOLTS Job Openings Rate, the NFIB Jobs Hard To Fill survey and the Consumer Confidence Jobs Plentiful less Hard To Get survey (Chart 3). As we have noted in past reports, the demand for labor has already fully recovered from the pandemic and it is the lack of labor supply that is holding back the employment recovery.1 That is, people are not making themselves available to work. When we think about possible reasons why people are not making themselves available for job opportunities, the most obvious candidates relate to the pandemic and the fiscal response to the pandemic. Table 2 shows the net number of jobs lost since February 2020 broken down by major industry group. It shows that the Leisure & Hospitality sector (mostly restaurants and bars) accounts for about one third of the net job loss. Together, the Education & Health Services and Government sectors account for another third. A lot of these missing jobs are close-proximity service industry jobs that pay a relatively low average hourly wage. It therefore shouldn’t be too surprising that people are reluctant to take these jobs due to fears of contracting COVID and the fact that they have received large income supplements from the federal government in the form of stimulus checks and expanded unemployment benefits. Table 2Employment By Industry It seems unlikely that these constraints to labor supply will persist beyond the next few months. Virus fears will ebb over time, as long as the case count remains low, and government income support will also go away. There will be no more stimulus checks and expanded unemployment benefits are scheduled to expire in September. Chart 4S&L Government Hiring Will Increase With this in mind, we expect that labor supply constraints will ease by end-summer/early-fall and the result will be significant upside surprises to nonfarm payroll growth. Bond yields will likely stay rangebound in the near-term, but the next significant move will be an increase in yields driven by strong employment data. As a final point on the labor market, we noted above that the Government sector accounts for about 15% of the net job loss since February 2020. In fact, all those missing government jobs are from state & local governments.2 State & local governments cut expenditures drastically last year, but thanks to a faster-than-expected recovery in tax revenues and generous transfers from the federal government, they actually saw overall revenues exceed expenditures in 2020 and again in the first quarter of 2021 (Chart 4). The upshot is that state & local governments are now in a position to ramp up spending, and their pace of hiring should accelerate in the coming months. Bottom Line: The Fed will ignore inflation for the time being and focus on its “maximum employment” target to decide when to lift rates off the zero bound. As a result, bond investors should also ignore inflation and focus on the employment data. We anticipate that significant positive nonfarm payroll surprises will start in late-summer/early-fall and that they will catalyze a move higher in bond yields. Keep portfolio duration below benchmark. A Note On Reverse Repos And Fed Operations Chart 5An Over-Supply Of Reserves Many investors have noticed that usage of the Fed’s Overnight Reverse Repo Facility (ON RRP) has surged during the past few weeks, and many are also wondering if this will force the Fed to alter its interest rate or balance sheet policies. The short answer is no. In fact, the increased take-up of the ON RRP is a sign that the Fed’s operational strategy is working as intended. Let’s explain. The Fed’s main task is to set a target range for the federal funds rate and then ensure that the funds rate stays within that range. Today, that target range is between 0% and 0.25%. The fed funds market is where banks trade reserves amongst each other. If the Fed has over-supplied the market with reserves, then they will be very cheap to acquire and the fed funds rate will fall. Conversely, if the Fed has under-supplied the market with reserves, they will be more expensive to acquire and the fed funds rate will rise. At present, the market is awash with reserves. This is the result of the Fed’s asset purchases and the Treasury department’s ongoing policy of reducing its cash holdings.3 This over-supply of reserves is forcing the fed funds rate down, toward the lower-end of the Fed’s target band (Chart 5). This is where the ON RRP comes to the rescue. Through the ON RRP, the Fed pledges to borrow reserves from any eligible counterparty at a rate of 0% using a security off its balance sheet as collateral. This effectively gives any eligible counterparty the option of depositing excess reserves at the Fed in return for a rate of 0%. The result is that the ON RRP establishes a firm floor of 0% under the fed funds rate. Chart 6An Under-Supply Of Reserves This is why we say that the ON RRP is working as intended. The market is currently over-supplied with bank reserves and the ON RRP is absorbing that excess while keeping the funds rate anchored within the Fed’s target range. We should note that, in addition to the ON RRP rate, the Fed also pays a rate of interest on excess reserves (IOER). This IOER rate is currently 0.10%. Much like the ON RRP, the IOER should function as a floor on interest rates since it promises banks a rate of 0.10% for excess reserves deposited at the Fed. The problem is that the IOER is only available to primary dealer banks that have accounts at the Federal Reserve. There are other major players in overnight money markets, such as the GSEs and large money market funds, and these institutions do not have access to the IOER, only to the ON RRP. It is this broader counterparty access that makes the ON RRP the true floor on interest rates. It’s also interesting to look back at a time when the Fed was grappling with the opposite issue. In September 2019 the Fed was supplying the market with too few reserves and the fed funds rate was rising as a result (Chart 6). During this period, the fed funds rate actually did briefly break above the top-end of the Fed’s target range. This is because the Fed does not have a standing facility to put a ceiling above rates the way that the ON RRP provides a floor. In September 2019, the Fed had to conduct ad-hoc repo operations – lending reserves in exchange for securities – in order to bring the funds rate back down. Fortunately, the Fed has plans to rectify this problem. The minutes from the last FOMC meeting reveal that a “substantial majority of participants” supported the establishment of a standing repo facility to serve as a ceiling on interest rates in the same way that the ON RRP serves as a floor. The establishment of such a facility will make it easier for the Fed to shrink the size of its balance sheet when the time comes. All in all, we see no implications for the Fed’s balance sheet or interest rate policies stemming from the recent uptick in ON RRP usage. It is possible that the Fed will decide to slightly increase the IOER or ON RRP rates at this month’s FOMC meeting in an effort to move the funds rate closer to the middle of its target band (the fed funds rate is currently 0.06%), but we don’t view this as a pressing need. It is more likely that the Fed will stay the course, knowing that the over-supply of reserves will abate once the Treasury’s cash balance re-normalizes and that the ON RRP will keep the funds rate well-anchored in the meantime. A Checklist For Liftoff Table 3The Fed’s Liftoff Checklist At the beginning of this report we claimed that, in determining when to lift rates off the zero bound, the Fed will ignore inflation and inflation expectations and will be guided only by the labor market. This claim stems from the three criteria that the Fed has said will determine the timing of liftoff (Table 3). Yes, above-target inflation is one of the items on the checklist. However, the checklist places no upper limit on inflation that would cause the Fed to ignore the checklist’s “maximum employment” criteria. Further, it’s highly likely that inflation will remain close to or above the Fed’s target at least through the end of 2022. In essence, this means that the inflation portion of the Fed’s liftoff checklist has been achieved and it is only employment that will determine the timing of liftoff. Inflation To see why inflation is likely to remain close to or above target levels we look at 12-month core CPI (Chart 7A) and 12-month core PCE (Chart 7B) and run some scenarios based on future monthly growth rates of 0.1%, 0.2%, 0.3% and 0.4%. For context, core CPI grew 0.9% in April and 0.7% in May. Core PCE grew 0.7% in April and May data have not yet been released. Chart 7A12-Month Core CPI Scenarios Chart 7B12-Month Core PCE Scenarios Charts 7A and 7B show that an average monthly growth rate of 0.2%, a significant drop from current rates, will cause 12-month core CPI and core PCE to level-off either at or above target levels and this leveling-off won’t even occur until the middle of next year. Given that we are likely to see at least a few more elevated monthly inflation prints, it is highly likely that inflation will be at or above the Fed’s target by the end of 2022. Employment As for the Fed’s “maximum employment” criteria, we have updated our scenarios for the average monthly pace of nonfarm payroll growth required to reach “maximum employment” by specific dates in the future. As a reminder, we define “maximum employment” as an unemployment rate between 3.5% and 4.5% and a labor force participation rate of 63.3%, equal to its February 2020 level. Our results are presented in Tables 4A-4C. We calculate that average monthly nonfarm payroll growth of between +378k and +462k is required to reach “maximum employment” by the end of 2022. As noted above, we expect that nonfarm payroll growth will come in far above this range starting in late-summer/early-fall. Table 4AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table 4BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table 4CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date All in all, we think that the Fed’s maximum employment and inflation criteria will both be met in time for a rate hike in 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the lack of labor supply please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 2 The federal government has added a net 24 thousand jobs since Feb. 2020. State & local governments have lost a net 1.2 million. 3  For more details on how the Treasury department’s cash management policy is influencing the supply of bank reserves please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The US business cycle is shifting into a slowdown stage: US economic and earnings growth will remain robust but decelerate from their peak.  Treasury rates have stabilized, and inflation fears, if not dissipated, have become priced in.  The consumer is flash with cash, and pent-up demand has not yet faded.  Demand for services exceeds demand for goods.  Valuations are rich, and short-term consolidation is likely. Considering this market backdrop, we recommend a barbell positioning for equity portfolios – a combination of Growth and Cyclicals: Shift allocation towards stable growth sectors, such as Technology, which are getting a shot in the arm from rates stabilization and the growth slowdown. Take a granular approach to selection of cyclical sectors and industries, with preference for the ones most exposed to consumer pent-up demand for goods and services and to a revival of global trade flows. Differentiate between Value and Cyclicals:  Cyclicals are more “growthy” than run-of-the-mill Value sectors.   Feature In our report of June 7, 2021, we outlined our investment framework. In this report we apply our investment principles to analyze the state of the equity markets today and derive investment recommendations. Business Cycle Is Shifting Into A Slowdown Stage The pandemic is barely over, but the markets have already galloped through both the recovery and expansion stages of the business cycle on the back of economic reopening, fiscal and monetary stimulus, and pent-up demand (Table 1). Table 1Stages Of The Business Cycle We posit that the business cycle is at the crest of the expansion stage and is shifting into a moderate slowdown. While growth is to remain robust, it has most likely peaked and is starting to decelerate: The ISM Composite reading is elevated but has slipped from a high of 64.2 in March to 62.6 in June (Chart 1). According to Bloomberg consensus estimates, GDP growth is to slow from 6.4% in 2021 to 4% in 2022. The earnings cycle is also peaking. In Q1-2021 US equities delivered 53% YoY earnings growth. Going forward, expectations are for 21% (Chart 2). Chart 1ISM Composite Has Peaked Chart 2EPS Growth Has Also Peaked While earnings growth is expected to remain robust, a change in pace often manifests itself in a change of market leadership from Value to Growth. Prices Set To Rise But At A Slower Pace Since the beginning of this year, investors’ eyes have been fixed on rising inflation readings. The crux of the debate was centered on whether high inflation is here to stay or is a transitory phenomenon. While we don’t have a definitive answer yet, there is a sufficient body of evidence to suggest that inflation is likely to decelerate. First, the 5-year inflation breakeven has stabilized indicating that the market expects consumer price increases to moderate (Chart 3). Second, the recent spike in the inflation reading has been exacerbated by the base effect of comparison with the darkest days of the pandemic in March-May 2020. Inflation troughed in June of 2020, which will anchor this coming summer’s inflation numbers to a higher base. (Chart 4). Chart 3Inflation Breakeven Stabilized Chart 4Base Effects Of The Spring 2020 Are To Roll Off Third, inflation is likely to dissipate to more normal levels later in the year thanks to millions rejoining the labor force upon expiration of supplemental employment insurance benefits in the fall, and the supply chain gradually becoming unclogged. Last, the bubble in commodities prices has burst with prices of lumber, corn and steel coming down from their highs by more than 30%, keeping a lid on PPI, and subsequently on the price of finished goods (Chart 5 & Chart 6) . Chart 5Bubble In Commodities Burst Chart 6PPI To Follow Commodity Prices Rates Are Stabilizing After rising by nearly 1% from 0.5% to 1.5% in the course of just four months from November 2020 to February 2021, the 10-year Treasury yield has been range bound between 1.5% and 1.7% despite fireworks in the US economic data ranging from CPI readings to unemployment beats (Chart 7). The fact that the bond market is refusing to budge no matter how positive a macro release number we get, confirms our view that a post Covid-19 economic revival and accelerated growth have been priced in. Case in point: The Citi Economic Surprise Index (CESI) turned down from its February highs and is approaching zero. Chart 7Rates Are Range Bound Since March Given the tight positive correlation (44%) between CESI and UST10Y, and inflation moderating, it is unlikely that the bond market will enter another aggressive sell-off phase (Chart 8). It is possible that rates will continue to grind higher over the summer, but the rate of ascent, which is more important for growth-oriented assets than the level (excluding extreme readings), is likely to be slow. Chart 8Positive Economic Data Is Priced In Consumers Are Flash With Cash After a series of helicopter cash drops, most consumers came out of the recession in a better financial shape than they entered it. According estimates by Peter G Peterson Foundation, only 22% and 19% of second and third round of stimulus checks have been spent (in addition, some of the money was used to pay off debt). Personal savings have increased by roughly $1.5 trillion from January 2020 trough, and disposable income has increased by 6% (Chart 9). With plentiful jobs and quit rates off the map, we expect consumer confidence to remain high and support spending. The investment implication is that we favor parts of the equity market most exposed to American consumer. Chart 9Consumers Are Flash With Cash Services Are In Higher Demand Than Goods After months of consumer behavior altered by fears of the pandemic, economic reopening has brought about strong demand for services. Indeed, the latest Non-manufacturing ISM PMI reading was 64 compared to 61 for Manufacturing, which has clearly peaked. As a result, we favor service sectors, both in the consumer and industrial space (Chart 10). Chart 10Demand For Services Outstrips Demand For Goods Global Trade Flows Are Soaring The global push for vaccinations and pent-up demand have jump-started trade flows around the globe. Despite shipping bottlenecks and container shortages, global trade is thriving, strengthening demand for industrial goods and transportation services (Chart 11). Chart 11Global Trade Soars Valuations Are Elevated The US equity market had a fantastic run over the past year, delivering 93% return from March 2020 trough, and is now trading at 30x trailing PE. Forward-looking PE is also elevated at 23x. About 40% of S&P 500 industry groups are trading in the top 10% of their historical valuations. In a way, markets have borrowed returns from the future (Chart 12). With valuations close to an all-time high, equity markets do not have much safety margin and are vulnerable to a correction which may be triggered by hawkish rhetoric from the Fed, or upside inflation or employment surprises. Having said that, we are bullish on equity markets on a three to six months horizon. Chart 12US Equities Are Expensive Lastly, high valuation is not necessarily an impediment to a continued bull market but more of a speed limit: Returns of US equities are to be modest going forward. To keep portfolio return volatility down and enhance compounding effects, we recommend carrying a healthy allocation to such defensive sectors as Health Care. We would stay away from bond proxies like Utilities and Telecom. Investment Implications To sum it all up: Economic and earnings growth is to remain robust but come down from the peak, inflation is to decelerate but stay high, rates are to remain stable, consumer spending is to stay robust, demand for services is to exceed demand for goods and global trade flows are soaring. What do these economic developments mean for portfolio positioning? What styles and sectors will fare best in the current economic environment? Growth does well when rates and inflation are stabilizing thanks to the long duration nature of its earnings stream, and shines in a slowdown when growth becomes scarcer. Cyclicals thrive in an environment of falling inflation, but a mature cycle is not an ideal backdrop for their outperformance. In terms of sector selection, we favor Cyclicals with exposure to consumers, playing growth through the “new economy”, i.e. Software and Services, and Internet Retailing. We will fund the new positions by taking profits from recent winners, Financials and Materials. The following is a brief rationale for these allocations. Value/Growth Rotation Between November 5, 2020 and May 7, 2021, long-duration Growth equities underperformed Value equities by 16%, beaten down by rising rates and accelerating economic growth. However, recently the case for Growth has strengthened. With rates stabilizing and inflation decelerating, there are already early signs that Growth stocks are staging a comeback, outperforming Value by 2.5% since May 10. Chart 13 shows that, in an enviroment of slowing inflation, Growth tends to outperform Value (Chart 14). Chart 13Growth Underperforms Value Since October 2020 Chart 14Growth Has Outperformed When Inflation Decelerates Further, peak economic and earnings growth, as well as the business cycle moving into a slowdown stage, bode well for Growth sectors (Chart 15). Chart 15Growth Shines In A Slowdown Stage Chart 16Growth Is Less Frothy Now Further, zooming into fundamentals and valuations, we observe that Growth stocks remain expensive, trading at a forward multiple of 27x, which is a 53% premium to Value, but some of the froth has come off as the style is now trading 3 points lower than back in December 2020 (Chart 16). Comparing Growth and Value earnings expectations, Value stocks are expected to grow about 10% faster than Growth stocks (Chart 17). The crux of the current Growth/Value dilemma is that, while optically Value is more attractive: cheaper than Growth and offering higher earnings growth, it is also much more sensitive to a slowdown in economic growth and rates stabilization (even if rates remain high). Thus, if we are right and rates and inflation have indeed steadied, and growth is slowing. Growth will outperform Value despite the latter’s superior fundamentals. The explanation lies in a sector composition of the two styles. Value’s top allocation is Financials, for which stabilizing rates and a flattening yield curve are detrimental. Growth’s top allocation is Information Technology (40% of the index), which thrives in an environment of lower growth and stable rates (Chart 18). All in all, we recommend topping up Growth sectors in a portfolio to be better positioned for an imminent change in regime. Chart 17Value Is Expected To Have Higher Earnings Growth Chart 18Growth Is Exposed To Tech, Value To Financials Cyclicals Vs Defensives Similarly to Value, Cyclicals have outperformed Defensives by about 10.7% since November. However, in March this rally ran out of steam, and relative returns remain range bound Chart 19. Further, performance of Cyclicals is sensitive to the stages of the business cycle. Normally, in a slowdown stage, Cyclicals lag. Chart 20 shows performance of Cyclicals during the slowdown stage of the business cycles. Chart 19Cyclicals Have Not Outperformed Defensives Since March Chart 20Slowdown Regime Doesn’t Favor Cyclicals However, this cycle may turn out somewhat different due to supply-chain disruptions and pent-up demand. Many of the conditions supporting Cyclicals are still in place: The potential infrastructure package, improving global trade and easy financial conditions. Earnings expectations relative to Defensives remain robust, and valuations have recently compressed from a 97% premium in February 2021, to 17% in May (Chart 21). Hence, we are not yet ready to give up on Cyclical stocks but will be granular in our allocations, favoring industry groups most exposed to services, global trade, infrastructure, and the US consumer. Chart 21Cyclicals Have Rerated Rel To Defensives Are Cyclicals The Same As Value? The reader may observe that we favor Cyclicals over Value and wonder if they are not one and the same. While recently Value and Cyclicals have been nearly 90% correlated (Chart 22), this relationship changes over time. Cyclicals have higher exposure than Value to stable growth sectors like Technology, and Consumer Discretionary (Chart 23). We prefer Cyclicals to Value because Technology is a quintessential growth sector favored by the current macroeconomic backdrop, and the Consumer Discretionary sector is exposed to increases in discretionary income and consumer demand for services. Choosing between Value and Cyclicals, we pick Cyclicals (Chart 23). Chart 22Relationship Between Value And Cyclicals Changes Over Time Chart 23Cyclicals Have More Exposure To Stable Growth Than Value  Investment Recommendations Overweight Growth-Oriented And Cyclical Sectors Growth-oriented industries groups and industries benefiting from rate stabilization, such as Software and IT Services, Semiconductors, and Internet Retail. Valuations are expensive but are justified by strong expected long-term earnings growth. Cyclical industries exposed to consumer demand for services and experiences, such as Hotels, Restaurants, Entertainment, and Airlines. Discretionary goods industry groups such as Autos & Components, and Consumer Durables. Industrial service-oriented industry groups, such as Transportation and Professional Services Global trade and infrastructure exposed industries such as Transportation, Construction and Engineering, and Building Materials. Equal Weight Defensive Sectors Health care valuations and returns have been subdued due to disruptions wrecked by the pandemic. However, in addition to trading at 16x forward earnings, the sector expects solid earnings growth (10% over the next 12 months) and is likely to benefit from post-Covid-19 normalization in health care and diminished policy risks. To be more specific, policy risk for Big Pharma is higher as it is a bipartisan target, while managed health care got a big positive policy surprise when Biden wisely decided earlier this year not to re-fight the health care battles of the Obama administration. Underweight Sectors Negatively Affected By Rate And Inflation Stabilization (Off High Levels) Rate stabilization and yield-curve flattening is detrimental to rate-sensitive sectors such as Banks and Insurance. Inflation deceleration will be detrimental to industry groups with high pricing power and high exposure to raw materials. Since commodities prices have rolled over, the Metals and Mining industry group may take a pause. We will also avoid bond-proxy sectors like Utilities and Consumer Staples: Rates have stabilized but a bull market in bonds is highly unlikely Bottom Line Peak growth, inflation and rates stabilization herald a new lease of life for Growth stocks. Strong consumption and pent-up demand for goods and services as well as a revival of global trade support further outperformance of Cyclicals.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights The ECB did not tighten policy, despite its upgrade to the Euro Area growth outlook. The rise in the Eurozone inflation will be transitory. The Euro Area continues to suffer from excessive slack, and current price pressures are narrow. The ECB rightfully worries about tightening financial conditions by prematurely removing monetary accommodation. The ECB does not want to move ahead of the release of its Strategy Review. Global growth is likely to experience a temporary hiccup this summer. The ECB will only taper its PEPP program in Q1 2022 with no firm announcement until Q4 2021. Stay overweight European peripheral bonds. Despite a favorable 18-month outlook, European cyclical equities face pronounced risks this summer. Investors should raise cash levels for now to keep dry powder for this fall. Feature At its policy meeting last week, the ECB refrained from adjusting policy. While the euro and bund yields barely budged on the news, Italian and Greek spreads narrowed a few basis point, welcoming the dissipating risk of decreased bond purchases. The ECB’s decision is in line with the analysis we published two weeks ago, which argued against the Governing Council hinting at a tapering of asset purchases at its June meeting.  Growing signs that the expected pick-up in the Eurozone inflation will be transitory and that China’s credit slowdown will negatively impact Europe increase our confidence that the ECB will not announce any adjustment to its asset purchases until the fourth quarter of 2021. This setup supports European peripheral bonds. However, it also points to a correction in European cyclical stocks. The ECB Announcement ECB President Christine Lagarde highlighted the need for a steady hand, with no policy change. The risks to growth are now “broadly balanced,” but enough uncertainty remains that removing accommodation too early still creates a much poorer risk/reward trade-off than maintaining the current policy. The ECB boosted its growth forecast in 2021 and 2022. As Table 1A illustrates, 2021 GDP growth was raised to 4.6% from 4% in March, and 2022 GDP growth was raised to 4.7% from 4.1%. Activity was left unchanged at 2.1% in 2023. The ECB and this publication are on the same page; Euro Area domestic activity will enjoy a welcomed fillip as a result of the re-opening of the economy, a response to the improving pace of vaccination across the continent. Moreover, the NGEU program will start disbursing funds this summer and will add another boost to growth. Despite this significant upgrade to anticipated growth, the ECB kept its accelerated pace of asset purchases in place, at least through the summer, because the inflation outlook remains below its target of “close but below 2%” durably. As Table 1B shows, the ECB expects HICP to hit 1.9% in 2021, but it will subsequently slow to 1.5% in 2022 and 1.4% in 2021. Table 1AUpgraded Growth Forecast Table 1BBelow Target Inflation Bottom Line: The ECB did not taper its PEPP purchases, because of uncertainty and below-target inflation. Too Many Deflationary Risks The policy stance of the ECB is appropriate on three levels. First, the case for Eurozone inflation to be transitory is even stronger than it is in the US. Second, financial conditions could easily deteriorate if the ECB were to tighten policy too early. Finally, the Strategy Review due this fall further paralyzes the ECB for now. Transitory Inflation Headline and core CPI in the Eurozone will increase significantly in the coming months but will slow next year. The ECB’s core CPI measure, which excludes food and energy, is set to rise above the levels of the past 15 years. As the US re-opened, core CPI spiked on both yearly and monthly bases. The presence of bottlenecks across domestic and global supply chains indicates that the Euro Area will experience a similar outcome. Assuming that monthly inflation rates will settle between 0.2% and 0.25% for the remainder of 2021, by year’s end, annual inflation will stand between 2% and 2.5% (Chart 1). The European PMI indices confirm the upside for the Euro Area’s core inflation. Service inflation has been more stable than in the US, but goods inflation is rising in line with the higher manufacturing PMI (Chart 2). Services inflation will accelerate according to the services PMI. Chart 1Higher Inflation For 2021 Chart 12Accelerating Goods And Services Inflation   Surveys confirm that this summer’s re-opening will jumpstart inflation. The employment components of both the European Commission’s Retail and Services Surveys are consistent with a rapid pickup in employment (Chart 3). This will support household income and consumption. Additionally, the EC’s Consumer Survey indicates that European households are ready to increase their purchase of homes and cars compared to last year (Chart 3, bottom panel). When stronger demand meets supply bottlenecks, higher prices ensue. Already, the EC’s Retail Survey points to this outcome (Chart 4). Despite these inflationary developments, most economic forces indicate that the Eurozone’s core and headline CPI will not stay elevated for long. Chart 3Stronger Employment In Pandemic-Hit Sectors Chart 4Re-Opening Pricing Pressures Our Trimmed Mean Inflation measure for the Euro Area (which mimics the construction of the Cleveland Fed Trimmed-Mean CPI in the US) has weakened to 0.1% (Chart 5). Hence, underlying inflation trends are still muted and the recent uptick in core CPI reflects outliers, as has been the case in the US. The outlook for the components of CPI confirms that any uptick in Euro Area inflation will be temporary. Shelter inflation, which accounts for 24% of the ECB core CPI, will rise as the unemployment rate declines. However, the strength in the euro is limiting import prices, which will cap non-energy industrial goods inflation (Chart 6). Moreover, the peak in oil price annual increases points toward a rollover in transportation inflation. Together, these two categories represent almost 60% of the core CPI components. Chart 5Inflation Is Not Broad-Based Chart 6Key CPI Components Will Slow Labor market dynamics are also consistent with a temporary inflation spurt. Total hours worked remain 6.5% below their pre-COVID-19 summit and underneath the level congruent with full employment based on the size of the Eurozone’s working-age population (Chart 7). This model understates the slack in the labor market, because the reforms implemented in peripheral economies in the wake of last decade’s Euro Area crisis have brought down structural unemployment. Moreover, the chart shows that, after total hours worked return to their equilibrium, it still takes a few years before negotiated wages firm up. Even if labor shortages materialized earlier than we anticipate, it does not guarantee a pickup in core CPI. From 2016 to 2019, a large proportion of Euro Area businesses cited labor shortages as a key factor limiting production. Yet, despite both this perceived tightness and a trendless euro, core CPI remained flat, averaging 1% per annum (Chart 8). Chart 7Still Too Much Slack Chart 8Labor Shortages Do Not Guarantee Inflation Outside of the labor market, the amount of stimulus injections also argues against a permanent increase in European inflation. BCA’s US Bond Strategy, Global Investment Strategy, and Bank Credit Analyst services believe that the current spurt of US Inflation is temporary, despite vast monetary and fiscal stimuli. In relation to 2019 GDP, the ECB’s liquidity injections have been larger than those of the Fed; however, the US fiscal activism greatly outdid that of the Eurozone (Chart 9). Consequently, the combined monetary and fiscal impulse in the US is larger, and its greater weight toward fiscal policy makes it more inflationary. Thus, if the US is unlikely to see durable inflation, the Eurozone is even less at risk. Chart 9More Timid European Stimulus Chart 10Lower European Inflation Expectations Euro Area inflation expectations are also muted compared to that of the US (Chart 10). This development confirms that Eurozone policy is less inflationary than that of the US. It also creates an anchor for realized inflation, which will constrain the acceleration in the Euro Area CPI. Financial Conditions The ECB is deeply concerned about the impact of the hurried removal of monetary accommodation on the Eurozone’s financial conditions. Chart 11The Euro Is Deflationary The ECB does not want to see a much more rapid pace of appreciation in the euro. If it begins to slow its QE program when the Fed remains reluctant to talk about tapering, EUR/USD will surge. This will feed into weaker core inflation in the region. The ECB’s broad trade-weighted euro, based on 41 currencies, has already rallied to a record high. Thus, an even more rapid euro rally would spell deeper deflationary pressures in the region (Chart 11). Peripheral spreads remain fragile. The ECB will not want to cause a rapid widening of Italian, Spanish, or Greek government bond spreads by decreasing its asset purchases prematurely. Otherwise, the health of the banking sector in the periphery will once again deteriorate, which will both harm the recovery and ignite deflationary tendencies. Strategy Review The ECB’s Strategy Review also prevents the Governing Council from adjusting policy. The ECB will release its Strategy Review in September or October. This exercise could result in a change to the inflation target. In line with the new Fed Average Inflation Target, the ECB objective may become more symmetric. Inflation has not hit the ECB’s target of nearly 2% since 2012, and the level of HICP stands 8% below what the target implies. Therefore, if the ECB adjusts its target this fall, it will become harder to justify the removal of accommodation. Bottom Line: The ECB wants to avoid a repeat of its 2011 policy mistake, when it tightened policy prematurely and catalyzed a period of profound weakness in the European economy. Eurozone inflation will increase this year; however, this bump is transitory and inflation will once again decline in 2022. Moreover, the ECB rightfully worries about tightening financial conditions, because the euro is exerting profound deflationary forces on the continent and peripheral spreads remain fragile. Finally, the ongoing Strategy Review limits what the ECB can do until its results are known. Look Out For Q4 2021 The ECB will keep the PEPP program in place until March 2022, as was originally announced. Therefore, the ECB will only telegraph its intention after the summer and will most likely announce in December its firm commitment to begin tapering. The program size does not constrain the ECB. The total envelope of the PEPP stands at EUR1850 billion, and the ECB has already purchased EUR1100 billion (Chart 12). Based on the current accelerated pace of purchases, the ECB will run out of room in February 2022. Thus, the ECB continues to enjoy great flexibility without adjusting the PEPP program meaningfully. Chart 12Plentiful PEPP Room Chart 13China Will Act As A Drag Chart 14The Global Growth Tax Is Biding The expanding threat of a global growth scare will likely limit the ability of the ECB to tighten policy ahead of Q4. China’s credit impulse is decelerating, which portends an imminent peak in our BCA Global Industrial Activity Nowcast (Chart 13). Moreover, the rise in global yields since August 2020 and the rapid rally in oil prices since April 2020 are consistent with a meaningful deceleration in global manufacturing activity. The collapse in our Global Leading Economic Indicator Diffusion Index also hints at a coming global soft patch (Chart 14). Hence, the heightened sensitivity of the Euro Area economy to the global manufacturing sector  points toward softer-than-anticipated growth this summer. Historically, a deceleration of the Chinese PMI New Orders components warns of a decline in the 1-year forward EONIA (Chart 15). While the ECB is unlikely to flag a rate reduction in response to the upcoming global deterioration, it could respond by delaying its tapering decision. Ultimately, the accumulation of constraints and risks suggests that, even after the PEPP taper starts in 2022, the ECB will roll it into the older PSPP program. The ECB will want to keep a lid on peripheral spreads and guarantee that the euro does not melt up. Germany is unlikely to block this initiative, because its large Target 2 surplus means that problems in the periphery will percolate to the German banking system (Chart 16). Moreover, Germany’s export sector will benefit from a euro whose appreciation is contained. Chart 15Chinese New Orders Are Inconsistent With A Tighter ECB Chart 16Germany Does Not Want Italian Troubles Bottom Line: The ECB will not formally announce its tapering until December 2021. The ECB still has considerable room to continue using the PEPP program, and the global economy is likely to generate a negative growth surprise this summer. Instead, once the PEPP taper begins in 2022, the program will be rolled into the PSPP rather than being completely discarded. European policy, therefore, will remain accommodative. Investment Implications A dovish ECB is consistent with a continued overweight in European peripheral bonds. Chart 17European Peripheral Bonds Remain Attractive Portuguese, Greek, Spanish, and Italian bonds offer much more attractive valuations than the global or the European averages (Chart 17). The robust pace of ECB bond purchases, along with the increased fiscal risk-sharing created by the NGEU programs, will allow this value to continue to generate excess returns for investors. The growth scare, however, threatens our positive stance on European equities and cyclical stocks. We expect a correction to take place this summer or early fall. Thus, investors should raise cash now to buy cyclicals stocks once they correct. First, a deceleration in global growth catalyzed by a Chinese credit slowdown is consistent with an underperformance of cyclical stocks and European stocks in general. Second, the ECB Central Bank Monitor currently sports an elevated 2.1 reading, which is negative for cyclicals. A high reading for the monitor materializes when the Eurozone economy is experiencing strong momentum. However, markets are forward looking, and they rapidly internalize a brightened outlook. Once the price of cyclical stocks embed enough good news, they will start to generate poorer returns. Consequently, positive readings of the monitor are followed by negative relative excess returns for cyclical stocks, such as Industrials, Financials, Tech, and Consumer discretionary on both 6- and 12-month horizons (Table 2A). Table 2AThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform The higher the ECB Monitor reaches, the worse the cyclical sectors’ excess returns become, even if the ECB does not tighten policy. Moreover, outliers do not distort the results of the study. The batting averages confirm that, the higher the ECB Monitor, the lower the probability of a subsequent outperformance of cyclicals. The reverse is true for defensive sectors. The higher the ECB Monitor climbs, the greater the subsequent 6- and 12-month relative excess returns for Telecommunication, Consumer Staples, Utilities, and Healthcare turn out. Their probability of outperformance also increases (Table 2B). Table 2BThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform Investors should therefore curtail their exposure to risk over the coming months, tactically tilt toward some attractive defensive names and buy some hedges or raise some cash in order to participate more fully in the rest of the rally later this year. Bottom Line: An easy ECB policy favors an overweight stance in European peripheral bonds. However, if global growth slows, the current reading of our ECB Monitor is consistent with a period of underperformance for cyclical equities. Such underperformance should correlate with a corrective episode for the broad market as well as an underperformance of European stocks relative to the US. Investors, therefore, should raise cash levels and tactically move into attractive defensive names in order to buy back cyclicals later this year.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance   Sector Performance​​​​​​​

Our recent fascination with the Chinese data continues, and today we look at the real M1 money supply series. In our previous research we highlighted that the change in the 10-year US Treasury yield (UST10Y) moves in tandem with ebbs and flows of the global manufacturing cycle (Chart 1). Now that the Chinese real M1 money supply has decisively peaked, it foreshadows a deceleration phase in the global manufacturing activity (Chart 2), and by extension in the UST10Y. As a reminder, we have also recently shown how the decline in the Citigroup US economic surprise index sends a similar message, indicating that US yields are unlikely to advance meaningfully. Bottom Line: Stabilization of the US bond market will help revive some of the beaten down growth names Chart 1 Chart 2