Australia

Executive Summary The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%.  Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Month In Review: A Continued Hawkish Shift Month In Review: A Continued Hawkish Shift Chart 2The Dollar Has Broken Above Overhead ##br##Resistance The Dollar Has Broken Above Overhead Resistance The Dollar Has Broken Above Overhead Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The Case For More Tightening The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire.  More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18.  The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears Too Many Yen Bears Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report  Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128.  British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The Case For A Hawkish BoE The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term.    Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The RBA Will Stay Patient The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year.  New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10.  The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon.          Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The BoC Will Hike Next Week The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around.  Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84.   Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world.  In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels.   Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind NOK Has A Policy Tailwind NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December.  Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK.   Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term.    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 Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone ​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral ​​​​​ Chart 8No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels ​​​​​​ Chart 12Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US ​​​​​​ Chart 14Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations ​​​​​​ Chart 15Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 18Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​​ Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase  

Executive Summary Refreshing Our Tactical Trade List A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Our current list of tactical trade recommendations centers around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We still see value in holding our recommended cross-country spread trades that will benefit from continued US bond underperformance (short US Treasuries versus government bonds in Germany, Canada and New Zealand, all at the 10-year maturity). We also maintain our bias to lean against the yield curve flattening trend in the US, but we now prefer to do it solely via our existing SOFR futures calendar spread position. Finding attractively valued inflation breakeven spread trades is more difficult after the latest oil-fueled run-up in developed market inflation expectations. Canadian breakevens, however, stand out as having the greatest upside potential according to our Comprehensive Breakeven Indicators. Bottom Line: Remain in US-Germany, US-Canada an US-New Zealand 10-year government bond yield spread widening trades. Maintain our recommended position in the US SOFR futures curve (long Dec/22 futures, short Dec/24 futures). Add a new inflation-linked bond trade, going long 10-year Canadian breakevens. Feature One month has passed since Russia invaded Ukraine, and investors are still struggling to sort out the financial market implications. Equity markets in the US and Europe have recovered the losses incurred immediately after the conflict began. Equity market volatility has also fallen back to pre-invasion levels according to the VIX index (and its European counterpart, the VStoxx index). That decline in equity volatility has also coincided with a narrowing of corporate credit spreads in both the US and Europe, with the former now fully back to pre-invasion levels. Yet while credit spread volatility has calmed down, government bond yield volatility remains elevated thanks to rising commodity prices putting upward pressure on expectations for inflation and monetary policy (Chart 1). Chart 1Global Bond Yields Are Above Pre-Invasion Levels Global Bond Yields Are Above Pre-Invasion Levels Global Bond Yields Are Above Pre-Invasion Levels ​​​​​​ Table 1Refreshing Our Tactical Trade List A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations We have already made some “wartime” adjustments to our global bond market cyclical recommendations, with those changes reflected in our model bond portfolio. This week, we review our shorter-term tactical trade recommendations. Our current list of tactical trades revolves around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger cyclical upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We continue to see the value in holding on to most of our existing tactical trades, with only a couple of adjustments to be made to our US yield curve and global inflation-linked bond positions (Table 1). US Yield Curve Tactical Trades: Shift Focus To SOFR Steepeners We have recommended trades that lean against the aggressive flattening of the US Treasury curve discounted in forward rates since late 2021. Our view has been that markets were discounting too rapid a pace of Fed rate increases in 2022. With the Fed likely delivering fewer hikes than expected, Treasury curve steepening trades would benefit as the spot Treasury curve would flatten by less than implied by the forwards. Related Report  Global Fixed Income StrategyFive Reasons To Tactically Increase US Duration Exposure Now Needless to say, that view has not panned out as we anticipated. The spread between 10-year and 2-year US Treasury yields now sits at a mere +13bps, down from +104bps when we initiated our 2-year/10-year steepener trade last November. The forwards now discount an inversion of that curve starting in June of this year, which would be an extraordinary outcome by historical standards. Typically, the US Treasury curve inverts only after the Fed has delivered an extended monetary tightening cycle that delivers multiple rate hikes over at least a 1-2 year period (Chart 2). Today, the curve has nearly inverted with the Fed having only delivered only a single 25bp rate increase earlier this month. Chart 2The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Of course, the Fed’s reaction function in the current cycle is different compared to the past. The Fed now follows an average inflation targeting framework that tolerates temporary inflation overshoots after periods when US inflation ran below the Fed’s 2% target. Now, however, the Fed has no choice but to respond to surging US inflation, which has been accelerating since September and is now at levels last seen in 1982. Chart 3Our SOFR Trade Is Similar To Our UST Curve Trade Our SOFR Trade Is Similar To Our UST Curve Trade Our SOFR Trade Is Similar To Our UST Curve Trade We still see the market pricing in too much Fed tightening this year and too few rate hikes in 2023/24. The US overnight index swap (OIS) curve now discounts 218bps of rate hikes in 2022, but 44bps of rate cuts between June 2023 and December 2024. We think a more likely scenario is the Fed doing less than discounted this year, as US inflation should show some deceleration in the latter half of 2022, but then continuing to raise rates in 2023 into 2024. We have expressed this view more specifically through an additional tactical trade that was initiated last month, going long the December 2022 3-month SOFR futures contract versus shorting the December 2024 3-month SOFR futures contract. This new trade is essentially a calendar spread trade between two futures contracts, but with a return profile that has looked quite similar to our 2-year/10-year US Treasury curve flattening trade (Chart 3). Having two tactical trades that are highly correlated, and which both are driven by the same theme of the Fed doing less this year and more over the next two years, is inefficient. We see the SOFR calendar spread trade as a more precise expression of our Fed policy view compared to the 2-year/10-year Treasury curve steepener. In addition, the SOFR trade now offers slightly better value after it has lagged the performance of the Treasury curve trade over the past couple of weeks. Thus, we are keeping this trade in our Tactical Overlay portfolio (see the table on page 15), while closing out our 2-year/10-year steepener at a loss of -92bps.1 Cross-Country Spread Trades: Keeping Betting On Relatively Higher US Yields In our Tactical Overlay portfolio, we currently have three recommended cross-country government bond spread trades that all have one thing in common – a sale of 10-year US Treasuries. The long side of the three trades are different (Germany, New Zealand and Canada), but the logic underlying all three trades is the same. The Fed will deliver more rate hikes than the central banks in the other countries. 10-year US Treasury-German Bund spread Chart 4UST-Bund Spread Is Too Low UST-Bund Spread Is Too Low UST-Bund Spread Is Too Low Expecting a wider US Treasury-German Bund spread remains our highest conviction view in G-10 government bond markets. This is a trade we have described as a more efficient way to position for rising US bond yields than a pure below-benchmark US duration stance. We have maintained that recommendation in both our model bond portfolio and our Tactical Overlay portfolio. For the latter, that trade was implemented using 10-year bond futures in both markets and is up 3.9% since initiation back in October 2021. The case for expecting even more Treasury-Bund spread widening remains strong, for several reasons: Underlying inflation remains higher in the US, particularly when looking at domestic sources of inflation like wages and service sector prices. Europe, which relies more heavily on Russia for its energy supplies than the US, is more at risk of a negative growth shock from the Ukraine conflict. Our fundamental model of the 10-year Treasury-Bund spread shows that the current level of the spread (+197bps) is about one full standard deviation below fair value, which itself is rising due to stronger US economic growth, faster US inflation and a more aggressive path for monetary tightening from the Fed relative to the ECB (Chart 4). The spread between our 24-month discounters in the US and Europe, which measure the amount of rate hikes priced into OIS curves for the two regions over the next two years, has proven to be good leading indicator of the 10-year Treasury-Bund spread. That discounter spread is currently at 99bps, levels last seen when the 10-year Treasury-Bund spread climbed to the 250-300bps range in 2017/18 (Chart 5). With the relative forward curves now discounting a slight narrowing of the US-German 10-year spread over the next year, betting on a wider spread does not suffer from negative carry. We are maintaining this trade in our Tactical Overlay portfolio with great conviction. 10-year US Treasury-Canada government bond spread We entered another cross-country spread trade involving a US Treasury short position earlier this month, in this case versus 10-year Canadian government bonds. This trade is a bet on relative monetary policy moves between the Fed and the Bank of Canada (BoC). Like the Fed, the BoC is facing a problem of high inflation and tight labor markets. Canadian core CPI inflation hit a 19-year high of 3.9% in January, while the Canadian unemployment rate is at a 3-year low of 5.5%. The US is facing even higher inflation and even lower unemployment, but one major difference between the two nations is the degree of household sector debt loads. Canada’s household debt/income ratio now stands at 180%, 55 percentage points higher than the equivalent US ratio, thanks to greater residential mortgage borrowing in Canada (Chart 6). Chart 5Stay Positioned For More UST-Bund Spread Widening Stay Positioned For More UST-Bund Spread Widening Stay Positioned For More UST-Bund Spread Widening The Canadian OIS curve is now discounting a peak policy rate of 3.1% in 2023, which is at the high end of the BoC’s estimated 1.75-2.75% range for the neutral policy rate. Chart 6The BoC Will Have Trouble Matching Fed Hawkishness The BoC Will Have Trouble Matching Fed Hawkishness The BoC Will Have Trouble Matching Fed Hawkishness ​​​​​ Elevated household debt will limit the BoC’s ability to lift rates that high, as this would trigger a major retrenchment of housing demand and a significant cooling of house prices. While the US is also facing issues with robust housing demand and high house prices, this is less of a factor that would limit Fed tightening relative to the BoC because US household balance sheets are not as levered as their Canadian counterparts. We are keeping our short US/long Canada spread trade (implemented using bond futures) in our Tactical Overlay portfolio, with the BoC unlikely to keep pace with the expected Fed rate increases over the next year (Chart 7). Chart 7Stay Positioned For A Narrower Canada-US Spread Stay Positioned For A Narrower Canada-US Spread Stay Positioned For A Narrower Canada-US Spread 10-year US Treasury-New Zealand government bond spread The third cross-country trade in our Tactical Overlay is 10-year New Zealand-US spread widening trade. Chart 8A Big Gap In NZ-US Relative Interest Rate Expectations A Big Gap In NZ-US Relative Interest Rate Expectations A Big Gap In NZ-US Relative Interest Rate Expectations ​​​​​​ Like the Germany and Canada spread trades, we expect the Fed to deliver more rate hikes than the Reserve Bank of New Zealand (RBNZ) which should push up US Treasury yields versus New Zealand equivalents. In the case of this trade, however, interest rate expectations in New Zealand are far more aggressive. Chart 9Stay Positioned For NZ-US Spread Tightening Stay Positioned For NZ-US Spread Tightening Stay Positioned For NZ-US Spread Tightening The RBNZ has already lifted its Official Cash Rate (OCR) by 75bps since starting the tightening cycle in mid-2021. The New Zealand OIS curve is now discounting an additional 253bps of rate hikes in this cycle, eventually reaching a peak OCR of 3.5% in June 2023. This would put the OCR into slightly restrictive territory based on the range of neutral rate estimates from the RBNZ’s various quantitative models (Chart 8). This contrasts to the pricing in the US OIS curve that places the peak in the fed funds rate at 2.8% next year before falling back to the low end of the FOMC’s 2.0-3.0% range of neutral estimates in 2024. Both the US and New Zealand are suffering from similarly high rates of inflation, with New Zealand headline inflation reaching 5.9% in the last available data from Q4/2021. However, while markets are already pricing in restrictive monetary settings in New Zealand, markets are yet to price in a similarly restrictive move in the fed funds rate. We continue to see scope for a narrowing of the New Zealand-US 10-year bond yield spread over at least the next six months. There has already been meaningful compression of the 2-year yield spread as US rate expectations have converged towards New Zealand levels (Chart 9) – we expect the 10-year spread to follow suit. Inflation Breakeven Trades: Swap Canada For Australia We currently have one inflation-linked bond (ILB) trade in our Tactical Overlay portfolio, betting on higher inflation breakevens in Australia. We initiated this trade last October, largely based on the signal from our suite of Comprehensive Breakeven Indicators (CBI) for the major developed economy ILB markets. The CBIs contain three components: the deviation from fair value from our 10-year breakeven spread models, the distance between realized headline inflation and the central bank target, and the gap between the 10-year breakeven and survey-based measures of longer-term inflation expectations. Those three measures are standardized and aggregated to form the CBI. Countries with lower CBIs have more upside potential for breakevens, and their ILBs should be favored over those from nations with higher CBIs. Chart 10Breaking Down Our Comprehensive Breakeven Inflation Indicators A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Chart 11Favor Canadian Inflation-Linked Bonds Vs. Australia Favor Canadian Inflation-Linked Bonds Vs. Australia Favor Canadian Inflation-Linked Bonds Vs. Australia Given the latest run-up in global inflation breakevens on the back of soaring oil prices, there are now no countries in our CBI universe that have a negative CBI (Chart 10). Canada has the lowest CBI, and thus the highest upside potential for breakeven spread widening. We are taking a modest profit of +40bps in our Australian breakeven trade, as we are approaching the self-imposed six-month holding period limit on our tactical trades and our Australian CBI is not indicating major upside for Australian breakevens.2 Based on the message from our indicators, we see a better case for entering a new tactical spread widening position in 10-year Canadian ILBs. A comparison of the CBIs between Canada and Australia shows that the Canadian 10-year inflation breakeven is well below our model-implied fair value, which incorporates both oil prices and currency levels (Chart 11). This contrasts to the Australian breakeven which is now well above fair value. A similar divergence appears when comparing breakeven spreads to survey-based measures of inflation expectations, with Canadian breakevens looking too “undervalued” compared to Australia. While realized headline inflation is above the respective central bank targets, especially in Canada, the valuation cushion makes the ILBs of the latter the better bargain of the two. The details of our new Canadian 10-year breakeven trade, where we go long the cash ILB and sell 10-year Canadian bond futures against it, are shown in our Tactical Overlay table on page 15.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The Treasury curve trade is actually a “butterfly” trade, where we have included an allocation to US 3-month Treasury bills (cash) to make the curve steepener duration-neutral. Thus, the trade is more specifically a position where we are long a 2-year US Treasury bullet and short a cash/10-year US Treasury barbell with a duration equal to that of the 2-year. 2     We have recently discovered an error in our how we have calculated the returns on the 10-year Australian futures leg of our Australian 10-year inflation breakeven widening trade. The final total return for our trade shown in the Tactical Overlay table on page 15 corrects for our error, and fortunately shows a significantly higher return than we have published in past reports. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Tactical Overlay Trades

Executive Summary Is Factor Investing Dead? Is Factor Investing Dead? Is Factor Investing Dead? After decades of outperformance, in the past few years equity factors have started to underperform the broad indexes. But this may just be because US-centric factor research and US-dominated global factor indexes have masked an underlying divergence in the behavior of factor premiums in major countries/regions. In this report, we identify differences in smart beta strategies in the US, euro area (EMU), UK, Japan, Canada, Australia, and emerging markets (EM). Quality and Minimum Volatility factors are the most consistent across all markets. However, the magnitude of the factor premiums varies significantly among certain countries/regions. These variations can be attributed to a factor’s differing exposure to the same sector in specific countries, as well as the diverse performance of the same sector in specific countries. Value/Growth is an inferior framework to sector positioning. Quality remains a better factor than Growth.   Bottom Line: Factor investing is still a viable investing approach, but investors should consider that factor premiums have diverged among major countries/regions. Factor strategies may be less profitable in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country/region. Feature Chart 1Diverging Factor Performance DIVERGING FACTOR PERFORMANCE DIVERGING FACTOR PERFORMANCE Late last year, quant hedge fund AQR announced it would cut back resources because poor performance had induced significant investor outflows.1 Based on MSCI’s diversified multi-factor (DMF) index, which is a bottom-up 4-factor-index (value, momentum, quality and size) optimized using Barra equity models,2 the global DMF index underperformed the MSCI ACWI by 21% between March 2018 (when the relative performance peaked) and the end of January 2022, even though it had outperformed by 373% over the previous 20 years (Chart 1, top panel). Many clients have asked: Is factor investing dead? As shown in Chart 1, however, MSCI Global DMF’s recent poor relative performance was driven largely by a 23.6% underperformance from the developed markets (DM), especially the US (33% underperformance) and Japan (23.6% underperformance), while the DMF index in the emerging markets (EM) lagged its benchmark by only about 1% in the same period. We have advocated a simple approach to factor allocation to smooth out the cyclicality of individual factors by equally weighting five time-tested factors: Quality, Momentum, Minimum Volatility (Min Vol), Value and Equal Weight. Our equally-weighted-5-factor aggregate (EW5) index is less volatile than the more sophisticatedly optimized DMF; it therefore suffered less underperformance in the same period. However, even with this approach, the regional divergence is still notable, with the EW5 factor index in the developing markets underperforming its benchmark by 9%, while the EM EW5 factor index outperformed its benchmark by about 5.5% (Chart 1, panels 2 and 3). Interestingly, the EW5 index for Japan looks more like that for the US than it looks like the Japanese DMF (Chart 1, panels 4 and 5). This highlights the importance of factor allocation methodology. Table 1US Dominance In Global Markets Is Factor Investing Dead? Is Factor Investing Dead? US equities dominate the global equity index by market capitalization. Momentum and Quality, the two best performing factors globally, have even higher weightings in US companies than the broad benchmark, as shown in Table 1. An academic paper published in 2019 based on studies of the US and 38 international stock markets indicates that the US is the only country with a statistically significant, economically meaningful and robust post-publication decline of long-short equity factor returns.3 This is because the US is the most researched market and large mispriced anomalies are arbitraged away quickly after they are identified in academic publications, which results in lower strategy returns. Most quant funds are US-focused, which may explain the ill fortunes of some quant funds. Smart beta strategies are long-only factor strategies, instead of long-short strategies. At the aggregate level, the MSCI factor indexes in developed markets and emerging markets performed much better than in the US, in line with the academic findings (Chart 1, panels 2, 3, and 4). Yet, the Japanese DMF index’s relative performance peaked in October 2012 and has been in a consistent down trend since that time (Chart 1, panel 5). Our research shows that Japan is not an anomaly. Factor divergence among countries exists not only at the aggregate level, but also at the individual factor level. Factor Performances Diverge Among Countries/Regions Factor returns in the US, UK, EMU, Japan, Canada, Australia, and EM, both in absolute and relative terms, have had notable divergences in the past 20 years, as shown in Table 2.4 Several observations from Table 2: Quality and Min Vol are two factors with positive premiums in all countries. In terms of magnitude, however, Min Vol premiums in the US, Japan and Australia are the closest to zero, while the EM scores the highest. Quality premium in Australia is also close to zero while the UK stands out. Momentum is the best performing factor in all countries/regions except in Japan where it has a slightly negative premium. The ineffectiveness of Momentum in Japan may be due to its cultural biases. Momentum tends to fare better in countries that promote individuality (unlike Japan) and where self-attribution and overconfidence are more pervasive. EM is the only market where our five preferred factors (Momentum, Quality, Min Vol, Value and Equal Weight) have had positive premiums, even though the Value premium is not statistically different from zero, while the Growth premium is negative. Despite the well-telegraphed underperformance of Value versus Growth in the US and global markets, this has not been the case in Japan, Canada, and the EM. Momentum, Quality, Min Vol and Value in the EM and Canada have much higher absolute returns than in the US. This aspect cannot be fully explained by the overall index performance difference between these countries and the US. Even though Momentum, Quality, Min Vol and Value in the UK and euro area have returned much less than their US counterparts, the magnitude of the underperformance of each factor is much smaller than what the overall index performance divergence would imply. Table 2Factor Performance Divergence* Is Factor Investing Dead? Is Factor Investing Dead? The widely quoted explanation for the impressive factor performance in the EM, especially in the Chinese A-share market, is that emerging markets have higher trading costs such that it’s harder to arbitrage away the mispriced anomalies. It’s true that trading cost is higher in the EM than in the US, which explains why there are fewer EM-dedicated quant funds than US-focused quant funds. Trading cost alone, however, cannot fully explain the exceptionally large premiums in EM Momentum, Quality and Min Vol compared with the US. In fact, the market with the best factor relative performance since the end of 2001 has been the UK (Chart 2) where trading costs are comparable to the US. The EM is the second in terms of relative returns even though it is more volatile than the euro area. Canada has also performed better than the US, while Australia has been the least favorable market to harvest any factor premium. Japan behaves more like the US, yet with higher volatility. The risk-adjusted active return, defined as the average of the return difference (between EW5 and benchmark) divided by the volatility of the return difference, on an annualized basis using monthly returns, is illustrated in Chart 3. The chart shows both the full-period (from December 2001 to January 2022) risk-adjusted active return (RAAR) and four-year moving RAAR to demonstrate how factors have evolved in each market. Several observations can be made from Chart 3: In the past 20 years, factor premiums (aka active factor returns) in the US have gone through three stages: High premium, low positive premium and then sharply declining premium to negative territory. The last stage started about four years ago. The US factor premium is at its lowest level in the past 20 years and is also the lowest among the seven countries/regions (Chart 3, panel 5). This supports the argument that too many quant funds trade with each other in the US equity market, resulting in lower and lower factor returns. Japan shares a similar pattern with the US, but on a much smaller scale (Chart 3, panel 4). Canada and Australia are similar because their indexes are dominated by financials and commodities. The four-year RAAR trends oscillate in a similar fashion in both countries, but the Canadian cycle seems to lead the Australian cycle by about 2-1/2 years. Canada has a meaningfully positive average factor premium and its four-year RAAR is near a historical low. In contrast, Australia’s average premium is close to zero and its four-year RAAR is still above previous lows (Chart 3, panels 6 and 7). The EMU is the only market with a positive four-year moving RAAR, currently at the well-established lower bound (Chart 3, panel 2). The UK has the highest average premium. It is the only market in which the four-year RAAR has had large cyclical swings and only two brief periods in negative territory (Chart 3, panel 1). EM is the only market where the four-year RAAR has improved since the Covid-19 pandemic started in March 2020 (Chart 3, panel 3). Chart 2Factor Relative Return Performance* FACTOR RELATIVE RETURN PERFORMANCE* FACTOR RELATIVE RETURN PERFORMANCE* Chart 3Risk-Adjusted Active Performance RISK-ADJUSTED ACTIVE PERFORMANCE* RISK-ADJUSTED ACTIVE PERFORMANCE* Bottom Line: US-centric factor research and the US-dominated global factor indexes have masked different behaviors of factors in various countries/regions. Thus, it is important to analyze each market instead of drawing investment conclusions from US-based research. What Drives The Divergence In Quality Premium? The Quality factor has been consistently rewarded, but the magnitude of the Quality premium varies significantly among countries/regions, and non-US countries have low correlations with the US, as shown in Table 2 (on page 4) and Charts 4 and 5. Chart 4Quality Performance Divergence* QUALITY PERFORMANCE DIVERGENCE* QUALITY PERFORMANCE DIVERGENCE* Chart 5Quality Premium* Country Correlation Is Factor Investing Dead? Is Factor Investing Dead? MSCI Quality is defined by three accounting measures: Return on equity (ROE), debt-to-equity and five-year volatility of EPS YoY growth. Earnings may be affected by accounting standards. Countries have different accounting standards, which may explain part of the country divergence in Quality. Our research focuses on an important aspect of Quality, which is persistence, i.e., a Quality stock today will be a Quality stock in the future. The implication is that the Quality factor index has a low turnover and its sector composition does not change much over time. As such, we can take a snapshot and see the relationship between Quality and sector exposure. The sector weights of the broad benchmark in each market are shown in Table 3. Notably, the US and EM have the highest exposure to the Tech sector while both the UK and Australia have little. Although Australia and Canada are both regarded as commodity-driven markets, they have dissimilar exposures to non-Financials: Australia is concentrated in Materials and Healthcare, while Canada has a more even exposure in Energy, Industrial, Materials and Tech. Table 3Broad Market Sector Compositions Is Factor Investing Dead? Is Factor Investing Dead? Given that Quality is measured on profitability, capital structure and earnings stability, does Quality show universal sector preference? The answer is both Yes and No. Yes, because Quality is universally underweight Financials, Energy and Utilities (Table 4). It is also overweight Tech and underweight Real Estate in all markets, except Australia. Tech has outperformed Financials, Utilities and Energy in general (except for Canada), therefore, these three sector tilts may explain the universal existence of Quality premium (Chart 6). Table 4Quality Index Sector Deviations Is Factor Investing Dead? Is Factor Investing Dead? Chart 6What Drives Quality Premium? WHAT DRIVES QUALITY PREMIUM? WHAT DRIVES QUALITY PREMIUM? However, the commonality ends here. Canadian Tech has underperformed Financials by a very large margin (Chart 6, panel 3), which would have caused a huge underperformance in Quality; Quality indexes in the UK and EMU have benchmark exposures to Tech. So what else have contributed to Quality’s outperformance in these three countries/regions? A look at their exposures to other sectors reveals the answers. In the UK, EMU and Canada, Quality indexes have also overweight tilts in Industrials, Consumer Discretionary and Consumer Staples (Table 4). These three sectors have all outperformed their respective benchmarks in the past 20 years, as shown in Table 5. The table also shows that Consumer Staples is the only sector that has outperformed in all markets, yet both US and Australian Quality indexes underweight this sector. Table 5Sector Performance* Is Factor Investing Dead? Is Factor Investing Dead? In addition, in both the UK and Canada, Quality overweights Materials, which is a top outperforming sector in the UK, but an underperforming sector in Canada. Materials also outperforms in the EMU, yet EMU Quality underweights it. Despite the impressive overall outperformance since 2001, the Quality factor in DM has suffered in the past few years, especially since the Covid 19-induced selloff in March 2020. Quality relative performance in EM peaked long before DM but has stood out as the only significant outperformer since March 2020. This is because profitability in Quality has improved in EM but deteriorated in the US and other DM countries as shown in Charts 7 and 8. Chart 7Quality Premium Driver: ROE* QUALITY PREMIUM DRIVER: ROE* QUALITY PREMIUM DRIVER: ROE* Chart 8Quality Premium Driver: EPS* QUALITY PREMIUM DRIVER: EPS* QUALITY PREMIUM DRIVER: EPS* Chart 9Quality Premium Driver: Valuation* QUALITY PREMIUM DRIVER-VALUATION* QUALITY PREMIUM DRIVER-VALUATION* Valuation-wise, Quality indexes in the UK and Canada are at their cheapest levels since 2013, while Japan has become more expensive. Meanwhile, Quality valuation in the US, EMU and Australia is in line with their respective historical average5 (Chart 9). Bottom Line: Quality premium is driven by profitability and has strong sector preferences. The divergence of Quality premium among countries indicates that the same sector in different countries does not necessarily share the same behavior relative to its own benchmark. Sector behaviors in each market have not been as consistent as globalization would have implied, even though “global sectors” have become a well-accepted concept. What Drives The Min Vol Premium Divergence? Beside Quality, Min Vol has consistently outperformed in all the countries/regions in the past 20 years, even though the premiums in the US and Japan are close to zero, as shown in Table 2 on page 4. Over time, however, Min Vol’s relative performance is very cyclical. At the global aggregate level, this cyclicality is determined by its defensive nature given its positive correlation with the relative equity return ratio of Defensives/Cyclicals and negative correlation with bond yields. It is no surprise that the strong recovery in global equities and the rise in bond yields have caused Min Vol to underperform the broad market since March 2020. What is surprising, however, is the magnitude of the underperformance, which cannot be explained by historical relationships (Chart 10). Chart 10What Drives Global Min Vol Premium? WHAT DRIVES GLOBAL MIN VOL PREMIUM? WHAT DRIVES GLOBAL MIN VOL PREMIUM? Looking at the global aggregate only, however, can provide misguided information, because Global Min Vol is dominated by the US (56.81%) and Japan (9.88%), where Min Vol has performed the worst. In the most recent cycle since March 2020, the US is the only country where Min Vol has deviated sharply from the historical relationship with the relative performance of defensives/cyclicals and with bond yields, incurring the largest relative performance drawdown ever, erasing all the relative gains achieved in the previous two decades (Chart 11A). Japanese Min Vol also suffered large drawdown, but was in line with the defensives/cyclicals, albeit undershooting what implied by the bond yield (Chart 11B). The relative performance of Min Vol in the UK, Canada, EM, and Australia all behaved in line with what is implied by the historical relationships with bond yields and defensives/cyclicals, while Min Vol in EMU does not have a close correlation with defensives/cyclicals (Charts 11 C-G). Chart 11AUS Min Vol Premium US MIN VOL PREMIUM US MIN VOL PREMIUM Chart 11BJapan Min Vol Premium JAPAN MIN VOL PREMIUM JAPAN MIN VOL PREMIUM Chart 11CUK Min Vol Premium UK MIN VOL PREMIUM UK MIN VOL PREMIUM Chart 11DEMU Min Vol Premium EMU MIN VOL PREMIUM EMU MIN VOL PREMIUM Chart 11ECanada Min Vol Premium CANADA MIN VOL PREMIUM CANADA MIN VOL PREMIUM Chart 11FAustralia Min Vol Premium AUSTRALIA MIN VOL PREMIUM AUSTRALIA MIN VOL PREMIUM   Chart 11GEM Min Vol Premium EM MIN VOL PREMIUM EM MIN VOL PREMIUM Min Vol has become the worst performing factor since March 2020, led by the US, Japan, and EMU, while the UK has been almost flat, as shown in Table 6. This is in stark contrast to its historical track record (Table 2 on page 4) but can be explained by its defensive tilt in a strong equity market. Currently, Min Vol’s general defensive nature is reflected by its overweight in Consumer Staples and underweight in Consumer Discretionary, overweight in Communication Services and underweight in Energy in all markets. In interest-rate-sensitive sectors, Min Vol overweighs Utilities in all markets except Japan and underweights Financials in all markets, except EM (Table 7). Table 6Min Vol Was The Worst Performer Since The Covid-Induced Recovery* Is Factor Investing Dead? Is Factor Investing Dead? Table 7Min Vol Index Sector Deviations Is Factor Investing Dead? Is Factor Investing Dead? Communication Services in the UK and Australia bucked the trend, outperforming the broad market. UK Financial also opposed the trend but did not outperform. In addition, the UK is overweight in Real Estate, which did much better than the broad market (Table 8). Table 8Sector Performance Since March 2020 Is Factor Investing Dead? Is Factor Investing Dead? Chart 12Min Vol Premium Divergence: Valuation* MIN VOL PREMIUM DIVERGENCE:VALUATION* MIN VOL PREMIUM DIVERGENCE:VALUATION* Min Vol in EM has an overweight in Financials, which also outperformed. In addition, EM Consumer Discretionary resisted the general trend, coming in under its benchmark by 17% annualized; an underweight in this sector contributed to EM’s Min Vol’s performance. Why has US Min Vol performed so badly? According to a GAA Special Report published in January 2020, extreme overvaluation of Min Vol relative to the broad market could induce poor subsequent performance in near future. US Min Vol reached peak valuation relative to the market in 2019, and the subsequent underperformance was accompanied by sharp multiple contraction. Currently, Min Vol’s relative valuation is in line with historical average in the US, implying the turnaround since November 2021 may have further staying power (Chart 12). Bottom Line: Global Min Vol’s defensive tilts explain its underperformance since March 2020. However, divergences in the magnitude of underperformance among countries is explained by different sector exposures and the varying performance of some sectors in different countries, in addition to relative valuation. Chart 13Value Vs. Growth: Is This Time Different? VALUE VS. GROWTH: IS THIS TIME DIFFERENT? VALUE VS. GROWTH: IS THIS TIME DIFFERENT? Is It Time To Overweight Value Versus Growth? This is one of the most frequently asked questions over the past few years, especially after the turnaround in AQR last year hit the newswire. The impressive performance of AQR so far this year has prompted more heated debate on the sustainability of the “Revenge of Value” after Value's longest streak of underperformance).6 The recent rebound in the relative performance of Value versus Growth has been driven by extremely oversold conditions, very cheap valuation and faster EPS growth led by the rise in global bond yields. Even though sector exposures change over time for Value and Growth, sector exposures to Financials and Tech have been stable since 2010 at the global aggregate level (Chart 13). The large bets in Financial, Utilities and Tech are universal, as shown in Table 9. Other sector exposures in specific countries vary significantly. For example, the US Value/Growth split is basically between Tech, Communication Services and Consumer Discretionary versus the other eight sectors. These three sectors are dominated by a few mega-cap stocks. The other eight sectors are a mixed bag of cyclicals, defensives, and interest rate sensitives, which have different macro drivers. It does not make sense to overweight them together. It is important to note that Consumer Staples and Healthcare are overweight in Growth outside the US and EMU. Table 9Sector Tilts In Value And Growth Is Factor Investing Dead? Is Factor Investing Dead? In addition, Growth has similar sector preferences as Quality (Table 4 and Table 9), which explains the high correlation between the two factor premiums (Chart 14A), However, Quality has been a much better factor than Growth outside the US and Australia. In the US, Quality and Growth are almost the same with a stable correlation, but Quality has been inferior to Growth in Australia (Chart 14B). Chart 14AClose Correlation* Between Quality And Growth CLOSE CORRELATION* BETWEEN QUALITY AND GROWTH, BUT... CLOSE CORRELATION* BETWEEN QUALITY AND GROWTH, BUT... Chart 14BQuality Is Superior To Growth Outside US And Australia QUALITY IS SUPERIOR TO GROWTH OUTSIDE US AND AUSTRALIA QUALITY IS SUPERIOR TO GROWTH OUTSIDE US AND AUSTRALIA Finally, Value and Growth behave very differently in various market-cap segments, as shown in Table 10. Despite the well-telegraphed underperformance of Value versus Growth by the media, Value has consistently outperformed Growth in Canada, EM and Japan. Furthermore, mid-cap Value has also outperformed mid-cap Growth universally. Image Bottom Line: Value is extremely cheap and the rebound from an extremely oversold condition has been supported by the relative earnings trend and a rise in interest rates. Yet the mixed bag of sector exposure makes the Value/Growth allocation inferior to sector allocation. Investors who want to focus on Growth are advised to look for Quality outside of the US and Australia. Conclusions Related Report  Global Asset AllocationValue? Growth? It Really Depends! The US-centric factor research and media coverage have masked an underlying divergence of factor premiums in specific countries/regions. Factor premiums in the UK, EMU, Canada, and EM have been stronger than in the US, while Japan and Australia have been weaker. This divergence can be explained by different sector exposures of the same factor, along with varying behaviors of the same sector in specific countries/regions. While factor investing is not dead, it may be less profitable to utilize in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country. Even though Quality, Min Vol and Momentum have been outperformers in the past 20 years, all factors have embedded cyclicality. We do not advocate factor timing and reiterate our long-standing approach of equally weighting the five factors to smooth out the cyclicality of individual factors. Value/Growth is a popular style split; however, it is an inferior framework to sector positioning. In addition, Quality is a better factor than Growth, which is already included in our five-factor approach.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1      Please see "Quant Hedge Fund Icon AQR Cuts Back as Investors Exit," Chief Investment Officer, dated November 15, 2021. 2     Please see "MSCI Diversified Multiple-Factorindexes Methodology," MSCI.com, dated May 2018. 3     Please see "Anomalies across the globe: Once public, no longer existent?" Journal of Financial Economics, Volume 135, Issue 1, January 2020, Pages 213-230. 4    Historical data for all MSCI factor indexes in major markets is available for this period 5    Since Jan 2013 based on MSCI data availability. 6     Jessica Hamlin, "AQR Posts Record Performance in January," Institutional Investor, dated February 9, 2022.

Executive Summary Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? The Russia/Ukraine conflict is impacting financial markets across numerous channels – uncertainty, risk aversion, growth expectations & inflation expectations – but all have a common link through soaring commodity prices, most notably for oil. For global bond investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. We recommend investors maintain neutral allocations to inflation-linked bonds versus nominal government bonds across the developed world until there is greater clarity on future global oil production. Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries. Bottom Line: The supply premium on global oil prices will persist until there are signs of more global oil production or less chaos in the Ukraine – neither of which is imminent. Maintain neutral allocations to inflation-linked bonds versus nominal government debt across the developed markets. Feature Chart 1A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices The Russia/Ukraine war has sent an inflationary shock though the world through a very traditional source – rising commodity prices. Energy prices are getting most of the attention, with oil prices back to levels last seen in 2008 and US gasoline prices now above $4 per gallon. The commodity rally is not just in energy, though. Industrial metals prices have also gone up substantially, with the spot prices for copper and aluminum hitting an all-time-high and 16-year-high, respectively (Chart 1). Agricultural commodities have seen even larger increases, with the price of wheat up 22% and the price of corn up 11% since the Russian invasion began on February 24th. Europe is acutely exposed to the war-driven spike in energy prices given its reliance on Russia for natural gas supplies. Natural gas prices in Europe have spiked a staggering 117% since the invasion started, exacerbating a sharp demand/supply imbalance dating back to the reopening of Europe’s economy from COVID lockdowns one year ago (Chart 2). To date, booming energy prices have fueled a huge rise in headline inflation rates in the euro area – producer prices were up 31% on a year-over-year basis in January – but with little trickle down to core inflation which was only up 2.3% in January. High energy prices are not only a problem for global growth and inflation, but also for the future policy moves by central banks. Inflation rates boosted over the past year by commodity supply squeezes and supply chain disruptions were set to decline this year, but the Ukraine shock has thrown that into question. If the benchmark Brent oil price were to hit $150/bbl, this would end the decelerating trend for energy price inflation momentum, on a year-over-year basis, that has been in place since mid-2021 (Chart 3). That means a higher floor for the energy component of inflation indices, and thus overall headline inflation rates, throughout the major economies in the coming months. Chart 2Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem ​​​​​ Chart 3Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? ​​​​​ Chart 4The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs How will bond markets respond to higher-than-expected inflation? Rate hike expectations have been highly correlated to the trend of headline inflation in the US, Europe, UK, Canada and Australia over the past year (Chart 4). Currently, overnight index swap (OIS) curves are still discounting between 5-6 rate hikes from the Fed, the Bank of England, the Bank of Canada and the Reserve Bank of Australia before the end of 2022. A single rate hike is still priced into the European OIS curve, even with the Ukraine shock. Global bond yields have been volatile, but surprisingly resilient despite the worries about war and commodity inflation. The 10-year Treasury yield has been trading in a range between 1.7% and 2% since the Russian offensive began, while the 10-year German Bund yield has hovered around 0%. Bond markets are pricing in a stagflation-type outcome of slowing growth and rising inflation, as multiple rate hikes are still discounted despite the geopolitical risks from the war. That reduces the value of using increased duration exposure to position for risk-off moves in a bond portfolio. At the same time, real bond yields are falling and breakeven rates are rising for global inflation-linked bonds – a part of the fixed income universe that looks to offer good protection against the uncertainties of war. Inflation-Linked Bonds – A Good Hedge Against War Risks Since the Russian invasion began, breakeven inflation rates on 10-year inflation-linked bonds have moved higher in the US (+13bps), Canada (+19bps), Australia (+15bps) and even Japan (+15bps). The moves have been even more significant on the European continent – 10-year breakevens have shot up in the UK (+23bps), Germany (+45bps), France (+31bps) and Italy (+36bps). Chart 5Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe The absolute levels of breakevens in Europe are high in the context of recent history (Chart 5). However, breakevens also look a bit stretched in other countries like the US. Our preferred metric to evaluate the upside potential for inflation-linked bonds is our Comprehensive Breakeven Indicators (CBI). The CBI for each country is comprised of three components: the deviation of 10-year breakevens from our model-implied fair value, the spread between 10-year breakevens and longer-term survey-based inflation expectations (the “inflation risk premium”) and the gap between actual inflation and the central bank inflation target. Those three components are all standardized and added together with equal weights to come up with the CBI. A higher CBI reading suggests less potential for inflation breakevens to widen, and vice versa. Currently, the CBIs for the eight countries in our Model Bond Portfolio universe are close to or above zero, suggesting more limited scope for breakevens to widen further (Chart 6). Only in Canada is the CBI below zero, and only slightly so as high realized Canadian inflation is offset by breakevens trading below both fair value and survey-based measures of inflation (Chart 7). Chart 6Global Inflation Breakeven Valuations Are Not That Cheap A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors In the US, the CBI is above zero mostly because of high realized US inflation. In Europe, the CBIs of the UK, Germany and Italy all are well above zero, while in France the CBI is close to zero. The UK has the highest CBI in our eight-country universe, with all three components contributing roughly equally (Chart 8). The Japanese CBI is also just above the zero line. Chart 7Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations ​​​​​​ Chart 8European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock ​​​​​​ We have been recommending a relative cautious allocation to global breakeven bonds in recent months. We saw the upside potential on breakevens as capped given the dearth of “cheap” signals on breakevens from our CBIs, especially with central banks moving towards monetary tightening in response to elevated inflation – moves intended to restore inflation-fighting credibility with bond markets. Yet the Ukraine commodity shock has boosted inflation breakevens even in countries with modest underlying (non-commodity) inflation like Japan and the euro area. We now see greater value in owning inflation-linked bonds in global bond portfolios as a hedge against the inflation risks stemming from the Ukraine and the worsening geopolitical tensions between the West and Russia. This is true even without the typical positive signal for breakevens from having CBIs below zero. We recommend that fixed income investors maintain a neutral allocation to inflation-linked bonds in dedicated government bond portfolios across the entire developed market “linker” universe. In our model bond portfolio, we had been allocating to linkers based off the signal from the CBIs, but in the current stagflationary war environment, we see country allocations as secondary to having neutral exposure to linkers in all countries. The new weightings to inflation-linked bonds are shown in the model bond portfolio tables on pages 12-14.1 Bottom Line: For global fixed income investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. Canada Update: BoC Liftoff At Last The Bank of Canada (BoC) raised its policy interest rate by 25bps to 0.5% last week, commencing the start of the first rate hike cycle since 2018. The move was no surprise after BoC Governor Tiff Macklem signaled at the January monetary policy meeting that the start of a rate hiking cycle was imminent. The Canadian Overnight Index Swap (OIS) curve is discounting another 171bps of hikes in 2022, with a peak rate of 1.98% reached by March 2023 - near the low-end of the BoC’s range of neutral rate estimates between 1.75% and 2.75% (Chart 9). Chart 9Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation The BoC noted that the Canadian economy was recovering faster than expected from the effects of the Omicron variant and the associated restrictions on activity, coming off a robust 6.7% annualized real GDP growth rate in Q4/2021. The BoC now estimates that economic slack created by the pandemic shock has been fully absorbed, with the unemployment rate at 6.5%. Canadian headline inflation reached a 32-year high of 5.1% in January (Chart 10) – a level that Governor Macklem bluntly called “too high” in a speech the day following the rate hike. The BoC’s CPI-trim measure that excludes the most volatile components is also at an elevated reading of 4%, suggesting that the higher inflation is broad based. The BoC sees persistent high inflation as a risk to the stability of medium-term inflation expectations, thus justifying tighter monetary policy. According the latest BoC Survey of Consumer Expectations, Canadians expect inflation to be 4.1% over the next two years and 3.5% over the next five years, both of which are above the BoC’s 1-3% inflation target band. So with a robust economy, tight labor market, inflation well above the BoC target and elevated consumer inflation expectations showing no signs of settling, why is the OIS curve discounting such a relatively low peak in the BoC policy rate? The answer lies with Canada’s housing bubble and the associated high household debt levels. In a recent Special Report, our colleagues at The Bank Credit Analyst estimated that the neutral rate in Canada was no higher than 1.75%- the previous peak in rates during the 2017-2018 tightening cycle. A big reason for that was the high level of Canadian household debt, which now sits at 180% of disposable income. This compares to the equivalent measure in the US of 124%, showing that unlike their southern neighbors, Canadian households had little appetite for deleveraging after the 2008 financial crisis (Chart 11). Chart 10Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC ​​​​​​ Chart 11A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC ​​​​​​ Chart 12Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads The Bank Credit Analyst report estimated that if the BoC hiked rates to 2.5% over the next two years – just below the high end of the BoC neutral range – the Canadian household debt service ratio would climb to a new high of 15.5% (bottom panel). This would greatly restrict Canadian consumer spending and likely trigger a sharp pullback in both housing demand and real estate prices. The conclusion: the neutral interest rate in Canada is likely closer to the peak seen during the previous 2018/19 hiking cycle around 1.75%. We have been recommending an underweight stance on Canadian government bonds in global fixed income portfolios dating back to the spring of 2021. However, with markets now discounting a peak in rates within plausible estimates of neutral, the window for additional underperformance of Canadian government bonds may be closing - but not equally versus all developed economies. We have found that a useful leading indicator of 10-year cross-country government bond yield spreads is the differential between our 24-month discounters. The discounters measure the cumulative amount of short-term interest rate increases over the next two years priced into OIS curves. Currently the “discounter gaps” are signaling room for Canadian spread widening versus the UK and Japan and, to a lesser extent, core Europe (Chart 12). However, the discounter gap is pointing to significant potential for narrowing of the Canada-US 10-year spread over the next year (top panel). This would occur even if the BoC follows the Fed with rate hikes in 2022, as the Fed is likely to deliver more increases in 2023/24 than the BoC. This week, we are introducing two new recommended positions to benefit from narrower Canada-US government bond spreads: We are reducing the size of our underweight position in our model bond portfolio in half, offset by a reduction in the allocation to US Treasuries (see the table on page 13). We are introducing a new trade in our Tactical Overlay, going long Canadian 10-year government bond futures versus selling 10-year US Treasury futures on a duration-matched basis (the specific details of the trade can be found in the table on page 15) We are maintaining our cyclical underweight recommendation on Canada, in a global bond portfolio context, given the potential for Canadian yield spreads to widen versus core Europe, Japan and the UK. That underweight recommendation will be more concentrated versus countries relative to the US. Bottom Line: Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The allocations to inflation-linked bonds shown in the model bond portfolio reflect both the recommended country weights and the recommended weighting of linkers versus nominal bonds within each country.  For example, we are neutral US TIPS versus nominal bonds within the US Treasury component of the portfolio, but since we are also underweight the US as a country allocation, the TIPS allocation is below the custom benchmark index weight. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors Tactical Overlay Trades

Executive Summary Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral The Russian invasion of Ukraine is a stagflationary shock that comes at a difficult time for developed market central banks that have been laying the groundwork for a tightening cycle. We tactically upgraded our recommended duration exposure in the US to neutral last week, as the market was pricing in too much Fed tightening in 2022. We are doing similar upgrades in non-US government bonds this week for the same reason. We are maintaining our cyclical country allocations, however, as those remain in line with interest rate pricing beyond 2022. We are underweight markets where terminal rate expectations remain too low (the US, UK & Canada) and overweight countries where markets are discounting too many rate hikes in 2023/24 (Germany, Japan, Australia). In light of the instability caused by the Russian invasion of Ukraine, we are reducing weightings in our model bond portfolio to credit sectors highly exposed to the war - European high-yield and emerging market hard currency debt. Bottom Line: The Ukraine war comes at a time when global growth momentum was already starting to roll over and with global inflation momentum set to peak soon. Upgrade duration exposure to neutral from underweight in global bond portfolios. Feature Among the tail risks that investors contemplated in their planning for 2022, World War III was likely not ranked too highly on the list. The horrific images of the Russian invasion of Ukraine – and the sharp response of the West to isolate Russia through unprecedented economic and financial sanctions - have shocked global financial markets that had been focused on relatively mundane concerns like the timing of interest rate hikes. BCA sent a short note to all clients late last week that discussed the investment implications of the invasion for several asset classes. In this report, we consider the bond market ramifications of war in Eastern Europe. Our main conclusion is that the Ukraine situation will produce a brief “stagflationary” shock that will boost global inflation and slow global growth, on the margin. High energy prices will be the main driver of that stagflation, given the uncertainties over the availability of Russian oil and natural gas supplies (Chart 1). Tighter financial conditions - beyond what has already occurred so far this year as global equity and credit markets have sold off (Chart 2) – will also contribute to the moderation of the pace of global growth. Chart 1A Mild Inflationary Shock From The Russian Invasion A Mild Inflationary Shock From The Russian Invasion A Mild Inflationary Shock From The Russian Invasion ​​​​​​ Chart 2The Ukraine War Is Adding To 2022 Risk-Off Trends The Ukraine War Is Adding To 2022 Risk-Off Trends The Ukraine War Is Adding To 2022 Risk-Off Trends ​​​​​​ The stagflation shock should be relatively short, perhaps 3-6 months. BCA’s Commodity & Energy Strategy service expects OPEC to eventually supply more oil to the global market – a move that was already likely before the Russian invasion – helping to reduce the Russian supply premium in oil prices. Putin will likely have to be satisfied with claiming eastern Ukraine rather than being stuck in a protracted battle with fierce Ukrainian resistance while Russia suffers under crippling sanctions. BCA’s Geopolitical Strategy service does not expect the conflict to spread beyond Ukraine’s borders, as neither Russia nor NATO have an interest in war with each other (despite the nuclear saber-rattling by Russian President Putin in response to Western sanctions). A mild bout of stagflation will only delay, and not derail, the cyclical move towards tighter global monetary policies in response to elevated inflation and tightening labor markets, particularly in the US. This will take some of the upward pressure off global bond yields as central banks will be less hawkish than expected in 2022, but does not change the outlook for higher bond yields in 2023 and 2024. In terms of changes to our fixed income investment recommendations, and the allocations to our Model Bond Portfolio, we come to the following three conclusions. Upgrade Tactical Non-US Duration Exposure To Neutral We recently upgraded our recommended tactical duration exposure in the US to neutral, with the Fed likely to deliver fewer rate hikes this year than what is discounted by markets. The Ukraine situation makes it even more likely that the Fed will underwhelm expectations. A 50bp rate hike at the March FOMC meeting is now off the table, as the equity and credit market selloffs in response to the conflict have tightened US (and global) financial conditions on the margin. However, the war is not enough of a negative shock to US growth to derail the Fed from starting a gradual tightening process this month with a 25bp hike. Our decision to change our US duration stance was largely predicated on a view that US inflation will soon peak and slow significantly over the rest of 2022. However, there is a strong case to increase non-US duration exposure, as well. Our Global Duration Indicator - comprised of leading cyclical growth indicators and which itself leads the year-over-year change in our “Major Countries” GDP-weighted aggregate of 10-year government bond yields by around six months - peaked back in February 2021 (Chart 3). The Global Duration Indicator is now at a “neutral” level consistent with more stable bond yield momentum. Declines in the ZEW economic expectations survey in the US and Europe, and in our global leading economic indicator, are the main culprits behind the fall in the Global Duration Indicator (Chart 4). Chart 3Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral Upgrade Global Duration Exposure To Neutral ​​​​​​ Chart 4Growth Expectations Have Turned Less Bond Bearish ... For Now Growth Expectations Have Turned Less Bond Bearish ... For Now Growth Expectations Have Turned Less Bond Bearish ... For Now ​​​​​ While the ZEW series have rebounded in the first two months of 2022, which could set the stage for a move back to higher yields later this year, the Ukraine situation will likely hurt economic expectations (particularly in Europe) in the near-term. We expect our Global Duration Indicator to continue signaling a more neutral backdrop for global bond yields over the next few months. In our Model Bond Portfolio on pages 13-14, we are expressing our view change by increasing the duration for all countries such that the overall duration of the portfolio is in line with the custom benchmark index (7.5 years). Importantly, we view this as only a tactical view change for the next few months, as developed economy interest rate markets are still discounting too few rate hikes – and in some countries like the UK and US, actual rate cuts – in 2023/24 (Chart 5). Chart 5Priced For Short, Shallow Hiking Cycles Priced For Short, Shallow Hiking Cycles Priced For Short, Shallow Hiking Cycles Maintain Cyclical Government Bond Country Allocations That Favor Lower Inflation Regions Chart 6Oil Is Inflationary Now, Will Be Disinflationary Later Oil Is Inflationary Now, Will Be Disinflationary Later Oil Is Inflationary Now, Will Be Disinflationary Later While we are neutralizing our global duration stance over a tactical time horizon (0-6 months), we are sticking with our current recommended cyclical (6-18 months) government bond country allocations. These are based on underlying inflation trends and the expected monetary policy response over the next couple of years. As noted earlier, BCA’s commodity strategists expect oil prices to fall from current war-elevated levels in response to increased supply from OPEC. The benchmark Brent oil price is forecasted to reach $88/bbl at the end of this year and $87/bbl and the end of 2023. The result will be a sharp decline in the year-over-year growth rate of oil prices that will help bring down headline inflation in all countries (Chart 6). Lower energy inflation, however, will not be the only factor reducing overall inflation across the developed world. Goods price inflation should also slow from current elevated levels over the next 6-12 months, as consumer spending patterns shift away from goods towards services with fewer pandemic-related restrictions on activity. Less goods spending will help ease some of the severe supply chain disruptions that have fueled the surge in global goods price inflation over the past year. That process has likely already begun – indices of global shipping costs have peaked and supplier delivery times have been shortening according to global manufacturing PMI surveys. The shift from less goods spending towards more services spending will lead to trends in overall inflation being determined more by services prices than goods prices. The central banks in countries that have higher underlying inflation, as evidenced by faster services inflation, will be under more pressure to tighten policy over the next couple of years. Therefore, our current cyclical recommended country allocations (and our Model Bond Portfolio weightings) within developed market government bonds reflect the relative trends in services inflation. We are currently recommending underweights in the US, UK and Canada where services inflation is currently close to 4%, well above the central bank 2% inflation targets (Chart 7). At the same time, we are recommending overweights in core Europe (Germany and France) and Australia, where services inflation is around 2.5%, and Japan where services prices are deflating (Chart 8). Chart 7Higher Underlying Inflation In Our Recommended Underweights Higher Underlying Inflation In Our Recommended Underweights Higher Underlying Inflation In Our Recommended Underweights ​​​​​​ Chart 8Lower Underlying Inflation In Our Recommended Overweights Lower Underlying Inflation In Our Recommended Overweights Lower Underlying Inflation In Our Recommended Overweights ​​​​​​ Chart 9Faster Wage Growth In Our Recommended Underweights Faster Wage Growth In Our Recommended Underweights Faster Wage Growth In Our Recommended Underweights The trends in services inflation are also reflected in wage growth in those same groups of countries – much higher in the US, UK and Canada compared to Australia, the euro area and Japan (Chart 9). We expect these relative trends to continue over the next 12-24 months, with higher underlying inflation pressures forcing the Fed, the Bank of England (BoE) and the Bank of Canada (BoC) to be much more hawkish, on a relative basis, than the European Central Bank (ECB), the Reserve Bank of Australia (RBA) and the Bank of Japan (BoJ). Our current bond allocations not only fit with underlying inflation trends, but also with market-based interest rate expectations. In Table 1, we show the pricing of interest rate expectations over the next few years, taken from Overnight Index Swap (OIS) forwards. We show the OIS projection for 1-month interest rates 12 months from now and 24 months from now. We also include 5-year/5-year forward OIS rates as a measure of market expectations of the terminal rate, a.k.a. the peak central bank policy rate over the next tightening cycle. In the table, we also added neutral policy rate estimates taken from central bank sources.1 Table 1Medium-Term Interest Rate Expectations Still Too Low In The US & UK Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World In the US and UK, the OIS rate projections two years out, as well as the 5-year/5-year forward rate, are below the range of neutral rate estimates. This justifies an underweight stance on both US Treasuries and UK Gilts with both the Fed and BoE now in tightening cycles. In Japan and Australia, the OIS projections are already within the range of neutral rate estimates, but the RBA and, especially, the BoJ are not yet signaling a need to begin normalizing the level of policy rates. This justifies an overweight stance on Australian government bonds and Japanese government bonds. In the euro area, OIS projections are below the range of neutral rate estimates, but the ECB is now signaling that any monetary tightening actions will need to be delayed because of the growth uncertainties stemming from the Ukraine conflict and high energy prices. Thus, an overweight stance on core European government debt is still warranted. In Canada, the OIS projections are within the range of neutral rate estimates, but the BoC has been preparing markets for a series of rate hikes. This makes our underweight stance on Canadian government bonds a more “mixed” call, although we remain confident that Canadian bonds will underperform in a global bond portfolio context versus European and Japanese government bonds. In sum, we see our recommended country allocations as the most efficient way to express our cyclical (medium-term) central bank views, given the strong link between forward interest rate expectations and longer-term bond yields (Chart 10). This is why we are not making changes to our country allocation recommendations alongside our move to tactically upgrade our global duration stance to neutral. Chart 10Too Much Tightening Priced Over The Next Year Too Much Tightening Priced Over The Next Year Too Much Tightening Priced Over The Next Year ​​​​​ Chart 11Bond Markets Not Priced For A Relatively More Hawkish Fed Bond Markets Not Priced For A Relatively More Hawkish Fed Bond Markets Not Priced For A Relatively More Hawkish Fed ​​​​​ Given our high-conviction view that markets are underestimating how high the Fed will need to lift interest rates in the upcoming tightening cycle – likely more than any other major developed economy central bank - positioning for US Treasury market underperformance on a 1-2 year horizon still looks like an attractive bet with forward rates priced for little change in US/non-US bond spreads (Chart 11). A wider US Treasury-German Bund spread remains our highest conviction cross-country spread recommendation. Reduce Spread Product Exposure In Europe & Emerging Markets Chart 12Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs Cut EM & European High-Yield Exposure, But Stay O/W Italian BTPs The geopolitical uncertainty stemming from the Ukraine war and the stagflationary near-term impact of high energy prices are negatives for all risk assets, on the margin. That leads us to tactically reduce the allocation to spread product to neutral versus government debt in our Model Bond Portfolio. We are implementing this by cutting allocations to riskier fixed income sectors that are most impacted by the Russia/Ukraine conflict – European high-yield corporate debt and emerging market (EM) USD-denominated hard currency debt (Chart 12). We had already been cautious on EM debt before the Russian invasion, with an underweight allocation to both USD-denominated sovereigns and corporates, so the latest moves just increase the size of the underweight. European high-yield, on the other hand, had been one of our highest conviction overweight positions – particularly versus US high-yield - entering 2022. However the Ukraine war is likely to have a bigger negative impact on the European economy than the US economy, thus we are cutting our recommended exposure to European high-yield only. The uncertainty of a war on European soil, combined with the spike in energy prices (especially natural gas), is negative for European growth momentum, reducing 2022 euro area real GDP growth by as much as 0.4 percentage points according to ECB estimates. This raises the hurdle for any ECB monetary tightening this year. An early taper of bond buying in the ECB’s Asset Purchase Program, an outcome that ECB officials claim is a required precursor to rate hikes, is now highly unlikely. Fears of reduced ECB bond buying had weighed on the relative performance of Italian government bonds last month, but a more dovish ECB policy stance should lead to lower Italian yields and a narrowing of the BTP-Bund spread (bottom panel). We continue to recommend a cyclical overweight stance on Italian government debt. A Final Thought We need to reiterate that the recommended changes made in this report – increasing global duration exposure to neutral and cutting EM and European high-yield – are over a tactical time horizon, largely in response to the Ukraine conflict. This is more of a “risk management” exercise, rather than a change in our fundamental cyclical views. We still believe global growth will remain above trend in 2022 and likely 2023, which will prevent a complete unwind of last year’s inflation surge, particularly in the US. We expect global bond yields to begin climbing again later this year and into 2023, and we envision an eventual return to a below-benchmark duration stance.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The sources of the neutral rate estimates are listed in the footnotes of Table 1. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Adjusting Our Bond Recommendations For A More Uncertain World Adjusting Our Bond Recommendations For A More Uncertain World Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades

Dear client, In addition to this weekly report, we sent you a Special Report from our Geopolitical Strategy service, highlighting the risk from the Russo-Ukrainian conflict. Kind regards, Chester Executive Summary The Ukraine crisis will lead to a period of strength for the DXY. Countries requiring foreign capital will be most at risk from an escalation in tensions. Portfolio flows have reaccelerated into the US, on the back of a rise in Treasury yields. This will be sustained in the near term. The euro area on the other hand has already witnessed significant portfolio outflows, on the back of Russo-Ukrainian tensions and an energy crisis. Countries with balance of payment surpluses like Switzerland and Australia are good havens amidst the carnage. Oil-producing countries such as Norway and Canada have also seen an improvement in their balance of payments, on the back of a strong terms-of-trade tailwind. This will be sustained in the near term. Balance Of Payments Across The G10 The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments Bottom Line: The dollar is king in a risk-off environment. That said, the US and the UK sport the worst balance of payments backdrops, while Norway, Switzerland, and Sweden have the best. This underpins our long-term preference for Scandinavian currencies in an FX portfolio. In the near term, we think the DXY will peak near 98-100, but volatility will swamp fundamental biases. Feature Chart 1The US Runs A Sizeable Deficit The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments The Russia-Ukraine conflict continues to dictate near-term FX movements. With Russia’s invasion of Ukraine, the risk of escalation and/or a miscalculation has risen. FX volatility is increasing sharply, and with it, the risk of a further selloff in currencies dependent on foreign capital inflows. As a reserve currency, the dollar has also been strong. It is difficult to ascertain how this imbroglio will end. However, in this week’s report, we look at which currencies are most vulnerable (and likely to stay vulnerable) from a balance of payments standpoint. Chart 1 plots the basic balance – the sum of the current account balance and foreign investment – across G10 countries. It shows that at first blush, Norway, Switzerland, Sweden, and Australia are the most resilient from a funding standpoint, while New Zealand, the UK, and the US are the most vulnerable. In Chart 2, we rank G10 currencies on eight different criteria: The basic balance, which we highlighted above. Real interest rate differentials, using the 10-year tenor and headline inflation. Relative growth fundamentals, as measured by the Markit manufacturing PMI. Three fair value models which we use in-house. The first is our Purchasing Power Parity model, which adjusts consumption basket weights across the G10 to reflect a more apples-to-apples comparison. The second is our long-term fair value model (LTFV), which adjusts for productivity differentials between countries; and the final is our intermediate-term timing model (ITTM), which separates procyclical from safe-haven currencies by including a risk factor such as corporate spreads. All three models are equally weighted in our rankings. The net international investment position (NIIP), which highlights currencies that are most likely to witness either repatriation flows or a positive income balance in the current account. Finally, net speculative positioning, which tells us which currencies have crowded long positions, and which ones sport a consensus sell. Chart 2The Scandinavian Currencies Are Attractive The Ukraine Crisis And Balance Of Payments The Ukraine Crisis And Balance Of Payments The conclusions from this chart are similar to our basic balance scenario – NOK, SEK, AUD, CHF, and JPY stand out as winners while GBP, NZD, and USD are the least attractive. The US dollar is a special case given its reserve currency status, with a persistent balance of payments deficit. The rise in the greenback amidst market volatility is a case in point. However, portfolio flows into the dollar also tend to be cyclical, so a resolution in the Ukraine/Russia conflict will put a cap on inflows. Equity portfolio flows had dominated financing of the US current account deficit but are relapsing (Chart 3). Bond portfolio flows have rebounded on the back of rising US yields, but US TIPS yields remain very low by historical standards (Chart 4). If they do not improve much further, specifically relative to other developed markets, it will be tough to justify further inflows into US Treasurys. Chart 3Equity Portfolio Flows Into The US Are Relapsing Equity Portfolio Flows Into The US Are Relapsing Equity Portfolio Flows Into The US Are Relapsing Chart 4Bond Portfolio Flows Into The US Are Strong Bond Portfolio Flows Into The US Are Strong Bond Portfolio Flows Into The US Are Strong In this week’s report, we look at the key drivers of balance of payments dynamics across the G10, starting with the US, especially amidst a scenario where the forfeit of foreign capital could come to the fore. United States Chart 5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US trade deficit continues to hit record lows at -$80.7 billion for the month of December. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasurys. A positive net income balance has allowed a slower deterioration in the US current account balance, though at -$214.8 billion for Q3, it remains close to record lows. The overall picture for both the trade and current account balance is more benign as a share of GDP, given robust GDP growth (Chart 5). That said, as a share of GDP, the trade balance stands at -3.5%, the worst in over a decade. Foreign direct investment into the US has been improving of late. This probably reflects an onshoring of manufacturing, triggered by the Covid-19 crisis. That said, despite this improvement, the US still sports a negative net FDI backdrop. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is still deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts worsening.       Euro Area Chart 6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The trade balance in the euro area has significantly deteriorated in recent quarters, on the back of an escalating energy crisis. Russia’s invasion of Ukraine marks the cherry on top. On a rolling 12-month basis, the trade surplus has fallen to 1% of GDP (Chart 6). This is particularly telling since for the month of December, the trade balance came in at €-4.6 billion, the worst since the euro area debt crisis. The current account continues to post a surplus of 2.6% of GDP, on the back of a positive income balance. However, FDI inflows are relapsing. After about two decades of underinvestment in the euro area, FDI inflows were at their highest level, to the tune of about 2% of GDP in 2021. Those have now completely reversed on the back of uncertainty. The combination of an energy crisis and dwindling FDI is crushing the euro area’s basic balance surplus. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Should the deterioration continue, it will undermine our longer-term bullish stance on the euro. It is encouraging that portfolio investments have turned less negative in recent quarters, as bond yields in the euro area are rising. Should this continue, it will be a good offset to the deterioration in FDI.   Japan Chart 7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Like the euro area, the trade balance in Japan continues to be severely hampered by rising energy imports. The trade deficit in January deteriorated to a near record of ¥2.2 trillion, even though export growth remained very robust. Income receipts from Japan’s large investment positions abroad continue to buffer the current account, but a resolution to the energy crisis will be necessary to stem Japan’s basic balance from deteriorating (Chart 7). The process of offshoring has sharply reversed since the Covid-19 crisis. While FDI is still deteriorating, it now stands at -2.4% of GDP, compared to -4.3% just before the pandemic. Net portfolio investments are also accelerating, especially given the rise in long-term interest rates in Japan, positive real rates, and the value bias of Japanese equities. We are buyers of the yen over the long term, but a further rise in global yields and energy prices are key risks to our view.             United Kingdom Chart 8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The UK has the worst trade balance in the G10, and the picture has not improved much since the pandemic (currently at -6.7% of GDP). Similar to both the euro area and Japan, much of the drag on the trade balance has been due to rising import costs from energy and fuels. This puts the UK at risk of an escalation in the conflict between Ukraine and Russia. Meanwhile, the improvement in the income balance over the last few years has started to deteriorate, as transfer payments under the Brexit withdrawal agreement kick in. As a result, the current account balance is deteriorating anew (Chart 8). Both portfolio and direct investment in the UK were robust in the post-Brexit environment but have started to deteriorate. This is critical since significant foreign investment is necessary to boost productivity in the UK and prevent the pound from adjusting much lower. With bond yields in the UK rising, and the FTSE heavy in cyclical stocks, this should limit further deterioration in the UK’s financial account. A significant drop in the estimated path of settlement payments for Brexit will also boost the income balance. The key for the pound over the coming years remains how fast the UK can improve productivity, which will convince foreign investors that the return on capital for UK assets will increase. Canada Chart 9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Canada’s domestic economy has been relatively insulated from the geopolitical shock in Europe, but its export sector is benefiting tremendously from it. Rising oil prices are boosting Canadian terms of trade. As a result, the current account has turned into a surplus for the first time since 2009, in part driven by an improving trade balance (Chart 9). Outside of trade, part of the improvement in the Canadian current account balance is specifically driven by income receipts from Canada’s positive net international investment position. At C$1.5 trillion, income receipts are becoming an important component of the current account balance. Foreign direct investment into Canada continues to remain robust, given strong commodity prices. This is boosting our basic balance measure, which today sits at a surplus of 2.4% of GDP and should continue to improve. Finally, because of Canada’s improving balance-of-payments backdrop, it is no longer reliant on foreign capital as it had been in the past, which supports the loonie.         Australia Chart 10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia continues to sport the best improvement in both its trade and current account balances over the last few years. As a result, the basic balance has eclipsed 4% of GDP for the first time since we have been measuring this series (Chart 10). The story for Australia remains improving terms of trade, specifically in the most desirable commodities – copper, high-grade iron ore, liquefied natural gas, and to a certain extent, high-grade coal. Foreign direct investment in Australia has eased significantly. Investment in projects in the resource space are now bearing fruit, easing the external funding constraint. Meanwhile, domestic savings can now be easily recycled for sustaining capital investment. In fact, foreign direct investment turned negative in Q4 2021. This also explains the drop in net portfolio investment since Australians now need to build a positive net international investment position. We have a limit buy on the Aussie dollar at 70 cents, as we are bullish the currency over a medium-term horizon.         New Zealand Chart 11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments For the third quarter of 2021, New Zealand’s current account balance hit record lows, despite robust commodity (agricultural) prices. Imports of fertilizers, crude oil, and vaccines have led to a widening trade deficit. A drop in the exports of wood also affected the balance. With a negative net international investment position of about 48% of GDP, the income balance also subtracted from the current account total (Chart 11). From a bigger-picture perspective, New Zealand’s basic balance has been negative for many years, as coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities, have kept the current account in structural deficit. However, as the prices of key agricultural goods head higher, New Zealand can begin to benefit from a terms-of-trade boom that will limit its external funding requirement. In that respect, portfolio investments are also improving. New Zealand has the highest bond yield in the G10, on the back of the highest policy rate so far (the RBNZ raised interest rates again this week). New Zealand’s defensive equity market has also corrected sharply amidst the general market riot. As such, foreign investors could begin to favor this market again based on high yields and a reset in valuations. Going forward, New Zealand should continue to see further improvement in its basic balance relative to the US, supporting the kiwi. Switzerland Chart 12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments The Swiss trade balance remains in a structural surplus, with a post Covid-19 boom that has led a new high as a share of   GDP (Chart 12). Global trade has been rather resilient due to high demand for goods. While Switzerland has a large net international investment position, income flows this quarter were hampered by servicing costs for foreign direct investments. The net international investment position did improve by CHF27 billion on a quarter-over-quarter basis in Q3, on the back of a net increase in foreign asset purchases. Currency movements also had little impact on the portfolio in Q3, which is atypical. The SNB will always have to contend with a structural trade surplus that puts upward pressure on the currency. This will keep the Swiss franc well bid, especially in times of crisis when the positive balance-of-payments backdrop makes the CHF a safe haven.             Norway Chart 13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Q3 2021 saw a strong recovery in Norway’s trade account that is likely to carry over to this year. A recovery in crude oil and natural gas prices was a welcome boon. The lack of tourism also boosted the services account (Norwegians travel and spend less abroad than foreigners visiting Norway). The ongoing electricity crisis in Europe was also an opportune export channel for Norway, which for the first time, opened its 450-mile-long, 1400-megawatt North Sea cable link to the UK. Positive income flows also benefit the current account and the krone (Chart 13). With one of the largest NIIPs in the world heavily skewed towards equity dividends, the NOK benefits when yields rise, even though the domestic fixed-income market is highly illiquid. While a resolution of the Russian-Ukrainian crisis could sap the geopolitical risk premium from oil, the reopening of the global economy will benefit Norwegian exports of oil and gas. Tepid investment in global oil and gas exploration will also ensure Norway’s terms of trade remain robust.       Sweden Chart 14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish current account balance has deteriorated slightly in the last few quarters, on the back of supply-side bottlenecks. Particularly, exports of cars have been hampered amidst a semiconductor shortage. That said, the primary income surplus remains a key pillar of the current account, keeping the basic balance at a healthy surplus of about 6% of GDP (Chart 14). Portfolio inflows into Sweden have dwindled, like most other European economies. If this has been due to geopolitical tensions in Europe, it will eventually prove to be fleeting. That said, the Riksbank remains one of the most dovish in the G10 and the OMX is also one of the most cyclical stock markets, which may have spooked short-term foreign investments. The Swedish krona has been the weakest G10 currency year-to-date. Given that we expect most of the headwinds to be temporary, and the basic balance backdrop remains solid, we will go long SEK versus both the euro and the US dollar.   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

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US A Growth Rotation Away From The US A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar US Dollar US Dollar Chart 5BUS Dollar US Dollar US Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Euro Euro Chart 6BEuro Euro Euro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Japanese Yen Japanese Yen Chart 7BJapanese Yen Japanese Yen Japanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound British Pound British Pound Chart 8BBritish Pound British Pound British Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Australian Dollar Australian Dollar Chart 9BAustralian Dollar Australian Dollar Australian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 10BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Canadian Dollar Canadian Dollar Chart 11BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Swiss Franc Swiss Franc Chart 12BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Norwegian Krone Norwegian Krone Chart 13BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Swedish Krona Swedish Krona Chart 14BSwedish Krona Swedish Krona Swedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary