Corporate Bonds

Executive Summary The Fed offered more explicit near-term forward rate guidance at its meeting last week. This guidance will reduce yield volatility at the front-end of the curve during the next few months. We expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before settling into a pattern of hiking by 25 bps at each meeting. Our anticipated Fed hike path is shallower than what is priced in the market, but it also lasts longer. Investors should position for this outcome by buying the December 2022 SOFR futures contract versus the December 2024 contract. Economic and financial market indicators suggest that the 10-year Treasury yield will fall back during the next six months, alongside falling inflation. Rate Expectations Rate Expectations Rate Expectations Bottom Line: Investors should keep portfolio duration close to benchmark for now, though we expect to get an opportunity to reduce portfolio duration later this year once inflation and bond yields are lower. Feature Last week was a chaotic one for the US bond market. Treasury yields rose and the Fed delivered its first 50 basis point rate increase since 2000. Yet, there is a broad consensus that the Fed’s message was dovish relative to expectations. In this week’s report we try to make sense of these confusing market signals. We do this by focusing on two important occurrences: (1) The Fed’s “dovish” 50 basis point rate hike and (2) The 10-year Treasury yield breaking above 3% for the first time since 2018. The Fed Takes Back Control Chart 1An Uncertain Rates Market An Uncertain Rates Market An Uncertain Rates Market Fed Chair Jay Powell had a clear agenda for last week’s FOMC press conference. Simply, he wanted to provide more concrete forward rate guidance to a market that had become increasingly volatile (Chart 1). The problem is that while the Fed had been explicit about its intention to lift rates, it hadn’t provided any firm guidance about its anticipated pace of tightening. This led to wild speculation in rates markets. Will the Fed lift rates at every meeting or every other meeting? Will it move in traditional 25 basis point increments or perhaps 50 basis point increments? Maybe even 75 basis point increments? This sort of speculation is unacceptable to Chair Powell who said in his opening remarks that the Fed “will strive to avoid adding uncertainty to what is already an extraordinarily challenging and uncertain time.”1 New Explicit Forward Guidance From Chair Powell’s post-meeting press conference, we can discern the following about the Fed’s near-term rate hike intentions. The Fed will not lift rates by 75 basis points at any single meeting. Two more 50 basis point rate hikes are likely at the June and July FOMC meetings. After July, the Fed will likely continue to lift rates at each FOMC meeting. Inflation’s trend will dictate whether these rate increases are delivered in 50 bps or 25 bps increments. The Fed will continue to lift rates at every meeting until it is confident that it has “done enough to get us on a path to restore price stability.” It’s also worth noting that, in addition to delivering a 50 basis point rate hike and providing firmer forward rate guidance, the Fed announced that it will begin shrinking its balance sheet on June 1. The Fed will follow the plan that was presented in the minutes from the March FOMC meeting and that we discussed in a recent report.2 Turning to markets, we see that the overnight index swap curve (OIS) is priced for an additional 201 bps of rate increases between now and the end of 2022 (Chart 2). This is consistent with three more 50 basis point rate hikes and two more 25 basis point rate hikes at this year’s five remaining FOMC meetings. If delivered, those hikes would bring the fed funds rate up to a range of 2.75% to 3.00%. Chart 2Rate Expectations Rate Expectations Rate Expectations Looking out until the end of 2023, we see the OIS curve priced for 262 bps of rate increases. That is, the market is priced for roughly 200 bps of tightening between now and the end of 2022, but only another 62 bps of rate increases in 2023. In fact, Chart 2 shows that the OIS curve has the funds rate peaking at 3.49% near the middle of 2023 and then edging slowly back down. Related Report  US Investment StrategyWage-Price Spiral? Not So Fast Based on our view that inflation will decline between now and the end of the year, we see the Fed delivering only 175 bps of additional tightening this year (50 bps rate hikes in June and July, followed by three more 25 bps hikes). This is slightly lower than what is priced in the curve. However, given the strong state of private sector balance sheets, we can also easily envision 25 basis point rate increases continuing at every meeting in 2023. That scenario would push the fed funds rate above 4% by the end of 2023, significantly higher than what is priced in the market. We recommend that investors position for this “slower, but longer” tightening cycle by buying the December 2022 SOFR futures contract versus the December 2024 contract (see “Yield Curve Trades” table on page 12). Charts 3A-3D focus more specifically on what’s priced in for the next few FOMC meetings. The charts show where the fed funds rate is expected to land after each meeting, as implied by the fed funds futures curve. Additionally, we use an ‘x’ to denote where we expect the fed funds rate to be at the end of each meeting. You can see that we expect the fed funds rate to be about 25 bps lower than the market by the end of September. Our expectation of a slower near-term hike pace stems from our view that inflation has already peaked.3 With that in mind, it’s notable that monthly core PCE inflation printed below levels consistent with the Fed’s 2022 forecasts in both February and March (Chart 4). In addition, last week’s employment report showed a significant deceleration in average hourly earnings (Chart 5). Average hourly earnings are an imperfect wage measure because they don’t adjust for the changing industry composition of the workforce. However, an adjusted measure that gives each industry group equal weighting is also starting to slow (Chart 5, bottom panel). Chart 3AMay 2022 FOMC Meeting May 2022 FOMC Meeting May 2022 FOMC Meeting Chart 3BJune 2022 FOMC Meeting June 2022 FOMC Meeting June 2022 FOMC Meeting Chart 3CJuly 2022 FOMC Meeting July 2022 FOMC Meeting July 2022 FOMC Meeting Chart 3DSeptember 2022 FOMC Meeting September 2022 FOMC Meeting September 2022 FOMC Meeting Chart 4Tracking Below The Fed's Forecast Tracking Below The Fed's Forecast Tracking Below The Fed's Forecast Chart 5Peak Wage Growth Peak Wage Growth Peak Wage Growth Bottom Line: The Fed’s more explicit rate guidance will reduce yield volatility at the front-end of the curve. Two more 50 basis point rate hikes are likely in June and July, but we expect falling inflation will prompt the Fed to switch to 25 basis point hikes after that. We also expect the tightening cycle to last longer than what is currently priced in the curve. Investors should keep portfolio duration close to benchmark and should position for our expected “slower, but longer” tightening cycle by owning the December 2022 SOFR futures contract versus the December 2024 contract. A Quick Note On The Neutral Rate And Financial Conditions Chart 6Financial Conditions Financial Conditions Financial Conditions Chart 2 shows that the market expects the Fed to lift the funds rate until it is slightly above the range of the Fed’s long-run neutral rate estimates (2% - 3%). At that point, restrictive monetary policy will presumably weigh on economic growth enough for the Fed to back away from tightening. While forecasters need some estimate of the neutral rate to predict where bond yields will land at the end of the cycle, it’s important to understand that Fed policymakers are not guided by these same concerns. In fact, Chair Powell said the following last week when asked whether the Fed intended to lift rates above estimates of neutral: … there’s not a bright line drawn on the road that tells us when we get [to neutral]. So we’re going to be looking at financial conditions, right. Our policy affects financial conditions and financial conditions affect the economy. So we’re going to be looking at the effect of our policy moves on financial conditions. Are they tightening appropriately? And then we’re going to be looking at the effects on the economy. And we’re going to be making a judgment about whether we’ve done enough to get us on a path to restore price stability. In other words, actual Fed policy will not be guided by neutral rate estimates. Instead, the Fed will continue lifting rates at a regular pace until it sees enough evidence of tightening financial conditions and slowing inflation. For this reason, it will be critical to monitor broad indexes of financial conditions as the Fed tightens policy. At present, the Goldman Sachs Financial Conditions Index remains deep in “accommodative” territory, but it is rising quickly (Chart 6). Based on history, we might expect the pace of tightening to slow once the index breaks into “restrictive” territory. Conversely, if financial conditions don’t tighten very much, then it will encourage the Fed to hike more aggressively.  The Return Of 3% Treasury Yields Chart 7Back Above 3% Back Above 3% Back Above 3% The 10-year Treasury yield broke above 3% after the FOMC meeting on Wednesday and it has so far held firm above that key psychological level. The last time the 10-year yield reached these heights was near the end of the last tightening cycle in 2018 (Chart 7). One big difference between today and 2018 being that today’s 3% 10-year yield consists of a much higher inflation component and a much lower real yield (Chart 7, bottom panel). At 2.88%, the cost of inflation compensation embedded in the 10-year yield is too high, and it will fall as inflation rolls over and the Fed tightens. There is a question, however, about whether this drop in 10-year inflation expectations will translate into a lower nominal bond yield or simply be offset by a rising 10-year real yield. The answer will depend on how quickly inflation comes down off its highs. Chart 85y5y Is Above Neutral 5y5y Is Above Neutral 5y5y Is Above Neutral If inflation falls quickly during the next few months, then the market will start to price-in a less aggressive Fed. This will hold down the 10-year real yield. However, if inflation remains sticky near its current level, then the market will judge that the Fed still has a lot of work to do. This will pressure 10-year real yields higher even if long-dated inflation expectations recede. It’s often simpler to ignore the breakdown between real yields and inflation expectations and focus purely on the nominal bond yield itself. This exercise strongly suggests that long-maturity nominal bond yields will fall back somewhat during the next six months. First, we observe that the 5-year/5-year forward Treasury yield has risen to 3.19%, above the upper-end of survey estimates of the long-run neutral fed funds rate (Chart 8). Long-maturity forward yields have rarely moved much above the range of neutral rate estimates during the past decade. Second, high-frequency indicators that historically correlate with bond yields have not justified the recent move higher in the 10-year yield. The ratio between the CRB Raw Industrials commodity price index and gold and the relative performance of cyclical versus defensive equity sectors have both stalled out, even as yields have shot up (Chart 9). Finally, the change in bond yields correlates strongly with the level of economic data surprises. Positive data surprises tend to coincide with a rising Treasury yield, and vice-versa. Economic data surprises have been positive during the past few months, justifying the move higher in yields (Chart 10). However, that trend is poised to reverse in the coming months. Economic momentum is bound to slow now that the Fed is tightening and the labor market is close to full employment. Further, the Economic Surprise Index exhibits a strong mean-reverting pattern. Extremely high values tend to be followed by lower values, and vice-versa. A simple auto-regressive model of the Surprise Index suggests that it is on track to turn negative within the next month. Chart 9Bonds Go Their Own Way Bonds Go Their Own Way Bonds Go Their Own Way Chart 10Economic Data Surprises Economic Data Surprises Economic Data Surprises Bottom Line: Our indicators suggest that the 10-year Treasury yield will fall back somewhat during the next six months. That said, on a longer-run horizon we continue to expect that interest rates will rise further than the market anticipates. Investors should maintain neutral portfolio duration for now, but stand ready to re-initiate below-benchmark positions later this year once inflation and bond yields are lower. A Quick Note On The Yield Curve And Credit Spreads Yield Curve Positioning Not only have bond yields increased since the Fed meeting last Wednesday, but the Treasury curve has also steepened significantly. The turnaround in the yield curve has been startling. The 2-year/10-year Treasury slope was inverted one month ago, but it is now back up to 40 bps (Chart 11). But despite the big moves in the 2/10 slope, the yield curve remains quite flat beyond the 5-year maturity point. In fact, the 2/5/10 butterfly spread – the 5-year yield minus the yield on a duration-matched 2/10 barbell – remains far too high compared to the 2/10 slope (Chart 11, bottom 2 panels). Therefore, our recommended yield curve positioning remains unchanged. Investors should buy the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Credit Spreads A steeper yield curve has positive implications for corporate bond spreads. All else equal, a steeper yield curve suggests that we are further away from the end of the economic recovery, meaning that corporate bonds have a longer window for outperformance. That said, at 40 bps, the 2-year/10-year Treasury slope is still relatively flat, and while corporate bond spreads have widened during the past few months, the high-yield index option-adjusted spread is still close to its 2019 level and the 12-month breakeven spread for the investment grade index is still below its median since 1995 (Chart 12). Chart 11Favor The 5-Year Favor The 5-Year Favor The 5-Year Chart 12Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation We remain cautious on corporate credit for the time being. Specifically, we recommend an underweight allocation (2 out of 5) to investment grade corporates and a neutral allocation (3 out of 5) to high-yield. However, if the 2-year/10-year Treasury slope were to steepen to above 50 bps and/or if corporate bond spreads were to widen further, then we may see an opportunity this year to tactically increase exposure. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1    https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.p… 2    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022. 3    Please see US Bond Strategy Weekly Report, “Peak Inflation,” dated April 19, 2022.   Recommended Portfolio Specification On A Dovish Hike And A 3% Bond Yield On A Dovish Hike And A 3% Bond Yield Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Chart 1Past Peak Inflation Past Peak Inflation Past Peak Inflation The Fed is all set to deliver a 50 basis point rate hike when it meets this week and with inflation still well above target Chair Powell will be keen to re-affirm the Fed’s commitment to tighter policy. However, with the market already priced for a 3% fed funds rate by the end of this year – 267 bps above the current level – we don’t see much scope for further hawkish surprises during the next eight months. Core PCE inflation posted a monthly growth rate of 0.29% in March. This is consistent with an annual rate of 3.6%, below the Fed’s median 4.1% forecast for 2022. Slowing economic activity between now and the end of the year will also weigh on inflation going forward (Chart 1). All in all, we see the Fed delivering close to (or slightly less) than the amount of tightening that is already priced into the curve for 2022. US bond investors should keep portfolio duration close to benchmark. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance No More Hawkish Surprises No More Hawkish Surprises Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 140 basis points in April, dragging year-to-date excess returns down to -292 bps. The average index option-adjusted spread widened 19 bps on the month to reach 135 bps, and our quality-adjusted 12-month breakeven spread moved up to its 48th percentile since 1995 (Chart 2). In a recent report we made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.1 First, we noted that while investment grade spreads had jumped off their 2021 lows, they remained close to the average level from 2017-19 (panel 2). Spreads have widened even further during the past two weeks, but they are not sufficiently attractive to entice us back into the market given the stage of the economic cycle. The 2-year/10-year Treasury slope has un-inverted, but it remains very flat at 19 bps. The flat curve tells us that we are in the mid-to-late stages of the economic cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Finally, we noted in our recent Special Report that corporate balance sheets are in excellent shape. In fact, total debt to net worth for the nonfinancial corporate sector has fallen to its lowest level since 2008 (bottom panel). Strong corporate balance sheets will prevent spreads from rising dramatically during the next 6-12 months, but with profit growth past its cyclical peak, balance sheets will look considerably worse by this time next year. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* No More Hawkish Surprises No More Hawkish Surprises High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 187 basis points in April, dragging year-to-date excess returns down to -281 bps. The average index option-adjusted spread widened 54 bps on the month to reach 379 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – shifted up to 4.7% (Chart 3). As we discussed in our recent Special Report, a very flat yield curve sends the same negative signal for high-yield returns as it does for investment grade.2 However, we maintain a neutral allocation to high-yield bonds compared to an underweight allocation to investment grade bonds for three reasons. First, relative valuation remains favorable for high-yield. The spread advantage in Ba-rated bonds over Baa-rated bonds continues to trade significantly above its pre-COVID low (panel 3). Second, there are historical precedents for high-yield bonds outperforming investment grade during periods when the yield curve is very flat but when corporate balance sheet health is strong. The 2006-07 period is a prime example. Finally, we calculate that the junk index spread embeds an expected 12-month default rate of 4.7%. Given our macroeconomic outlook, we expect the high-yield default rate to be in the neighborhood of 3% during the next 12 months. This would be consistent with high-yield outperforming duration-matched Treasuries.     MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in April, dragging year-to-date excess returns down to -178 bps. We discussed the incredibly poor performance of Agency MBS in last week’s report.3 We noted that MBS’ poor performance has been driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see potential for yields to fall somewhat during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market (EM) bonds underperformed the duration-equivalent Treasury index by 92 basis points in April, dragging year-to-date excess returns down to -592 bps. EM Sovereigns underperformed the Treasury benchmark by 181 bps on the month, dragging year-to-date excess returns down to -779 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 37 bps, dragging year-to-date excess returns down to -474 bps. The EM Sovereign Index underperformed duration-equivalent US corporate bonds by 2 bps in April. The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we continue to recommend a maximum underweight allocation (1 out of 5) to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 79 bps in April (Chart 5). This index continues to offer a significant yield advantage versus US corporates (panel 4). As such, it makes sense to maintain a neutral allocation (3 out of 5) to the sector. The EM manufacturing PMI fell into contractionary territory in March (bottom panel). The wide divergence between US and EM PMIs will pressure the US dollar higher relative to EM currencies. This argues for the continued underperformance of hard currency EM assets. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 17 basis points in April, dragging year-to-date excess returns down to -139 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread product volatility. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers even as economic growth slows and federal fiscal thrust turns into drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni/Treasury yield ratio is currently 94%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2).    We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 94%. The same measure for 17-year+ Revenue bonds stands at 99%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve rose dramatically and steepened in April. The 2-year/10-year Treasury slope steepened 15 bps, from 4 bps to 19 bps. Meanwhile, the 5-year/30-year slope steepened 2 bps, from 2 bps to 4 bps. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.4 For example, the 5-year/10-year Treasury slope is -3 bps while the 3-month/5-year slope is 209 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes (with another 50 bps due tomorrow) and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced but lasts longer, as is our expectation. We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 113 basis points in April, bringing year-to-date excess returns up to +387 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month to reach 2.90% and the 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps to reach 2.47%. The 10-year TIPS breakeven inflation has moved up to well above the Fed’s 2.3%-2.5% comfort zone (Chart 8) and the 5-year/5-year forward breakeven rate is at the top-end of that range. Concurrently, our TIPS Breakeven Valuation Indicator has shifted into “expensive” territory (panel 2). In a recent report we made the case for why inflation has already peaked for the year.5  Given that outlook and the message from our valuation indicator, it makes sense to underweight TIPS versus nominal Treasuries on a 6-12 month horizon. In addition to trending down, we expect the TIPS breakeven inflation curve to steepen as inflation heads lower between now and the end of the year. This is because short-maturity inflation expectations are more tightly linked to the incoming inflation data than long-maturity expectations. Investors can position for this outcome by entering inflation curve steepeners or real (TIPS) yield curve flatteners. We also continue to recommend holding an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in April, dragging year-to-date excess returns down to -38 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -32 bps. Non-Aaa ABS underperformed by 16 bps on the month, dragging year-to-date excess returns down to -67 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in April, dragging year-to-date excess returns down to -84 bps. Aaa Non-Agency CMBS underperformed Treasuries by 2 bps on the month, dragging year-to-date excess returns down to -69 bps. Non-Aaa Non-Agency CMBS underperformed by 18 bps on the month, dragging year-to-date excess returns down to -128 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, last week’s Q1 GDP report confirmed that commercial real estate (CRE) investment remains weak (Chart 10, panel 4). Weak investment will continue to support CRE price appreciation (panel 3) which will benefit CMBS spreads. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -43 bps. The average index option-adjusted spread widened 2 bps on the month. It currently sits at 50 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 296 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. No More Hawkish Surprises No More Hawkish Surprises Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 29, 2022) No More Hawkish Surprises No More Hawkish Surprises Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 29, 2022) No More Hawkish Surprises No More Hawkish Surprises Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -56 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) No More Hawkish Surprises No More Hawkish Surprises Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of April 29, 2022) No More Hawkish Surprises No More Hawkish Surprises   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 3 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 4 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 5 Please see US Bond Strategy Weekly Report, “Peak Inflation”, dated April 19, 2022. Recommended Portfolio Specification Other Recommendations   Treasury Index Returns Spread Product Returns

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

Executive Summary Spreads Near 2017-19 Average Spreads Near 2017-19 Average Spreads Near 2017-19 Average The main indicators that determine corporate bond performance are valuation, the cyclical/monetary environment and corporate balance sheet health. US corporate bond valuation is quite expensive. Spreads are off their post-COVID lows, but consistent with the 2017-19 average. The flat 2-year/10-year Treasury curve indicates that the cyclical/monetary backdrop is relatively poor. What’s more, the yield curve could easily invert within the next few months as the Fed tightens. This would send an even more negative signal for corporate bond returns.  Corporate balance sheets are currently in excellent shape, but their health will deteriorate within the next 12 months as profit growth slows and interest rates rise. Relative valuation favors high-yield over investment grade corporates, and high-yield has a track record of outperformance during periods of restrictive monetary conditions and strong corporate balance sheets. Bottom Line: Investors should cyclically reduce exposure to US corporate bonds while retaining a preference for high-yield over investment grade. We recommend downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5). Feature Chart 1A Rapid Recovery A Rapid Recovery A Rapid Recovery US corporate bonds have had a very good run since the March 2020 peak in spreads. Investment grade corporates outperformed a duration-matched position in US Treasuries by 23% during the first 12 months of the recovery, the best 12-month excess return since 2010 (Chart 1). That same period also saw an extremely rapid re-normalization of credit spreads. It took just 11 months for the investment grade corporate index option-adjusted spread (OAS) to reach 90 bps following its March 2020 peak, and the index delivered an annualized excess return of 26% during that period. In contrast, it took 109 months for the index OAS to reach 90 bps following the 2008 recession and corporates only beat duration-matched Treasuries by an annualized 4% during that time (Table 1). Table 1US Investment Grade Corporate Bond Returns From Spread Peak Until 90 BPs Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds The outlook for US corporate bond returns looks much different today. Spreads are tighter and the Fed is rapidly removing policy accommodation. Against this backdrop, we decided last week to cyclically reduce our corporate bond exposure.1  Specifically, we recommended downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5) within US bond portfolios. This Special Report discusses the rationale for our recent decision. First, we examine trends in the main indicators that determine corporate bond performance. These indicators fall into three categories: (i) valuation, (ii) cyclical/monetary indicators and (iii) balance sheet health. We then discuss the outlook for the relative performance of high-yield versus investment grade corporates. Valuation Starting with a simple examination of the average investment grade index OAS, we see that the spread has widened somewhat off its pre- and post-pandemic lows, but remains close to the average level seen between 2017 and 2019 (Chart 2). The index OAS is a reasonable gauge of value relative to recent history, but for a longer historical perspective we should adjust the index to account for its changing average credit rating and duration. To do this, we first re-weight the index to maintain a constant distribution between the different credit rating buckets. Next, we control for the index’s changing duration by calculating a 12-month breakeven spread. The 12-month breakeven spread is the spread widening that must occur during the next 12 months for the corporate index to perform in line with a duration-matched position in Treasuries. It can be approximated by dividing the index OAS by average index duration. Finally, Chart 3 presents the 12-month breakeven spread as a percentile rank since 1995. It shows that, after controlling for credit rating and duration, the investment grade corporate index has only been more expensive than current levels 24% of the time since 1995. Notice that the spread bounced off the 0% line in late-2021, indicating that it had reached all-time expensive levels. Chart 2Spreads Near 2017-19 Average Spreads Near 2017-19 Average Spreads Near 2017-19 Average Chart 3Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation All in all, we can conclude that investment grade corporate bonds are quite expensive. Spreads aren’t so low that they would justify an underweight allocation in a supportive cyclical/monetary environment. But they are tight enough that it makes sense to proceed cautiously in a neutral or negative cyclical/monetary environment, like the one we are in today.   Cyclical/Monetary Indicators The slope of the yield curve is the key variable we use to assess the current state of the cyclical/monetary environment. A very flat or inverted yield curve signals a relatively restrictive monetary policy backdrop, and we have shown that such a backdrop tends to coincide with poor excess corporate bond returns. Conversely, we have found that corporate bonds perform best early in the economic recovery when the yield curve is very steep. This steep yield curve signals that monetary conditions are highly accommodative, and thus supportive of credit spread tightening. Today, the yield curve is sending a somewhat confusing message. The 2-year/10-year Treasury slope briefly inverted last week, and it remains flat at 22 bps. Meanwhile, the 3-month/10-year Treasury slope is very steep, up above 200 bps (Chart 4)! Chart 4Conflicting Signals From The Yield Curve Conflicting Signals From The Yield Curve Conflicting Signals From The Yield Curve We discussed how to interpret the signals from different yield curve segments in a recent Special Report.2 We found that the 2-year/10-year Treasury slope sends the most useful signal for corporate bond excess returns, and we therefore view current cyclical/monetary conditions as negative for corporate bonds. In Table 2 we split each of the past six economic cycles into phases based on the 2-year/10-year Treasury slope. We define Phase 1 of the cycle as the period from the end of the prior recession until the 2-year/10-year slope breaks below 50 bps. Phase 2 of the cycle encompasses the time when the slope is between 0 bps and 50 bps. Phase 3 of the cycle spans from when the yield curve inverts until the start of the next recession. Table 2US Corporate Bond Performance In Different Phases Of The Cycle Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds The table shows annualized excess returns for both investment grade and high-yield corporate bonds in each of the three phases, and those returns exhibit a clear pattern. Returns are best in Phase 1 when the yield curve is steep. They take a step down in Phase 2 when the slope is between 0 bps and 50 bps, though they usually stay positive. Negative returns are most likely in Phase 3, after the yield curve inverts. Chart 5Limited Room For Curve Steepening Limited Room For Curve Steepening Limited Room For Curve Steepening With the 2-year/10-year Treasury slope at 22 bps, we are firmly in Phase 2 of the cycle. However, we could easily see the 2-year/10-year slope invert within the next few months while a breakout above 50 bps seems less likely. In fact, there are only two ways in which the 2-year/10-year Treasury slope can steepen further from current levels. First, the market could bid up its expectation of the long-run neutral fed funds rate, pushing long-dated bond yields higher. Second, expectations for the pace of near-term Fed tightening could diminish, pulling short-dated yields down. At the long-end, the 5-year/5-year forward Treasury yield is already above survey estimates of the long-run neutral rate (Chart 5). At the front-end, the market is discounting a rapid pace of 272 bps of tightening during the next 12 months (Chart 5, bottom panel), but that pace has limited room to fall given current extremely high inflation readings. Turning back to a comparison of the signals from the 2-year/10-year slope and 3-month/10-year slope, it is worth pointing out that the 3-month/10-year slope is influenced by yield movements at the very front-end of the curve. Meanwhile, the 2-year/10-year slope is purely a function of rate expectations beyond the next two years. As a result, we can view the 3-month/10-year slope as sending a timelier signal about Fed rate hikes and cuts, while the 2-year/10-year slope gives a better reading of how the market views the ultimate economic impact of Fed actions. For example, the 3-month/10-year Treasury slope inverted in 2019 just before the Fed started cutting rates (Chart 6A). The 2-year/10-year slope, however, only briefly dipped below zero. The message from the market was that the Fed would cut rates, but those cuts would be sufficient to sustain the economic recovery. As a result, corporate bonds performed well during this period, consistent with the message from the 2-year/10-year slope. Another interesting example occurred in early 2000 (Chart 6B). This time, the 2-year/10-year Treasury slope inverted while the 3-month/10-year slope remained steep. In this case, the 3-month/10-year slope was telling us that Fed rate hikes would continue, while the 2-year/10-year slope was telling us that those hikes would eventually kill the economic recovery. Once again, corporate bonds took their cues from the 2-year/10-year Treasury slope and performed poorly during this period. Chart 6AStrong Performance In 2019 Strong Performance In 2019 Strong Performance In 2019 Chart 6BPoor Performance In 2000 Poor Performance In 2000 Poor Performance In 2000 Obviously, the current situation looks more like 2000 than 2019, but with the 2-year/10-year slope still positive there remains scope for positive excess corporate bond returns in the near-term. That said, with high odds of 2-year/10-year curve inversion within the next few months and spreads at relatively tight levels, it makes sense to scale back exposure today in advance of the worst phase of the cycle. Balance Sheet Health The final factor we consider is the health of nonfinancial corporate sector balance sheets, and in fact, this is currently the lone bright spot for corporate bond investors. Our Corporate Health Monitor (CHM), a composite indicator of six key balance sheet ratios, is deep in “improving health” territory (Chart 7). This positive signal is driven by exceptionally high Interest Coverage (Chart 7, panel 2) and Free Cash Flow-To-Debt that is just off its highs (Chart 7, panel 3). Return On Capital is up sharply since 2020 but has not recovered its previous peak (Chart 7, bottom panel). Chart 7Balance Sheets Are In Great Shape Balance Sheets Are In Great Shape Balance Sheets Are In Great Shape While corporate balance sheets are in excellent shape right now, their health will certainly deteriorate going forward as profit growth comes down off its highs and interest rates rise. The only question is whether this deterioration will happen slowly or quickly. Turning to history, two relevant periods stand out (Chart 8). First is the mid-1990s when investment grade corporate bond excess returns peaked in July 1997, 16 months before our CHM moved into “deteriorating health” territory. Conversely, the CHM sent a negative signal before the excess return peak in 2007. But even then, investment grade corporates only outperformed Treasuries by an annualized 0.8% between when the 2-year/10-year slope fell below 50 bps in 2005 and when the CHM moved above zero in 2006. In other words, investors didn’t sacrifice much return by heeding the yield curve’s signal even when the CHM was deep in “improving health” territory. Chart 8Cyclical Corporate Bond Performance Cyclical Corporate Bond Performance Cyclical Corporate Bond Performance Investment Conclusions In summary, we view corporate bond valuations as expensive, and the flat 2-year/10-year Treasury slope suggests that the economic recovery is in its mid-to-late stages. Corporate balance sheets are currently in excellent shape, but they will deteriorate going forward as profit growth slows and interest rates rise. The above three factors suggest that corporate bonds could continue to outperform duration-matched Treasuries in the near-term. However, with spreads already at tight levels, we likely aren’t sacrificing much in the way of excess returns by turning cyclically defensive today. This move also ensures that we will not be invested when the credit cycle eventually turns and corporate bond spreads move significantly wider. Retain A Preference For High-Yield Versus Investment Grade While we recommend downgrading allocations for both investment grade (from neutral to underweight) and high-yield (from overweight to neutral), we think investors should still retain a preference for high-yield corporates over investment grade. To see why, let’s return to the 2005-06 period we looked at in the previous section. The yield curve dipped below 50 bps in 2005 when the CHM was still deep in “improving health” territory, and while investment grade corporate bond returns were low during the time between the signal from the yield curve and the signal from the CHM, junk excess returns were very strong (Chart 9). This makes some sense intuitively. Higher-rated investment grade corporates responded negatively to the Federal Reserve’s removal of monetary policy accommodation, but lower-rated junk spreads stayed well bid because actual default risk was benign. It wasn’t until after the CHM rose above zero that junk bonds started to underperform. In terms of present-day valuations, much like for investment grade, junk spreads are up off their 2021 lows. However, they remain close to their pre-pandemic trough (Chart 10). We also note that the differential between high-yield and investment grade spreads was much tighter in 2006-07. Given the similarities between that period and today, we wouldn’t be surprised to see junk spreads compress further relative to investment grade. Chart 9The Bullish Case For Junk The Bullish Case For Junk The Bullish Case For Junk Chart 10High-Yield Valuation High-Yield Valuation High-Yield Valuation Another way to approach high-yield bond valuation is through the lens of our Default-Adjusted Spread. The Default-Adjusted Spread is the difference between the junk index OAS and 12-month default losses, and we have shown that it has a strong correlation with excess returns (Table 3). Specifically, a Default-Adjusted Spread above 100 bps usually coincides with positive excess junk returns versus Treasuries, and higher spreads tend to coincide with higher returns. Table 3The Default-Adjusted Spread & High-Yield Excess Returns Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds To estimate the Default-Adjusted Spread for the next 12 months we need assumptions for the default and recovery rates (Chart 11). To do this, we model the 12-month speculative grade default rate as a function of gross nonfinancial corporate leverage – total debt over pre-tax profits – and lagged C&I lending standards. We then model the 12-month recovery rate based on the default rate itself. Chart 11Default And Recovery Rate Models Default And Recovery Rate Models Default And Recovery Rate Models Corporate pre-tax profit growth was exceptionally strong during the past 12 months, and we expect it to slow significantly going forward. Profit growth can be modeled as a function of nominal GDP growth and unit labor costs (Chart 12). If we assume that nominal GDP growth comes in at 7.3% this year (the Fed’s median 2.8% real GDP estimate plus 4.5% inflation) and that unit labor cost growth rises to 6%, then profit growth will fall to 0.5% during the next 12 months. If we assume that corporate debt growth remains close to its current level (Chart 12, bottom panel), then we calculate that gross leverage will rise to 6.5 during the next 12 months. Chart 12Profit Growth Will Slow Significantly Profit Growth Will Slow Significantly Profit Growth Will Slow Significantly Table 4 shows the output from our default and recovery rate models under the base case assumption described above. It also shows results for an optimistic case where leverage is 6.0 and a pessimistic case where it is 7.0. The Default-Adjusted Spread is fairly low in the base and pessimistic cases, but it is comfortably above the key 100 bps threshold in all three scenarios. This suggests that junk bonds should deliver positive excess returns versus duration-matched Treasuries during the next 12 months. Table 4Default-Adjusted Spread Scenarios Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Portfolio Allocation Summary, “The Beginning Of The End”, dated April 5, 2022. 2 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds Other Recommendations Turning Defensive On US Corporate Bonds Turning Defensive On US Corporate Bonds

Highlights Chart 1Reduce Credit Exposure Reduce Credit Exposure Reduce Credit Exposure Corporate bond spreads staged a nice rally during the past month. The average index spread for investment grade corporates is only 22 bps above its pre-COVID low and 33 bps above last year’s trough. The average High-Yield index spread is 5 bps above its pre-COVID low and 49 bps above last year’s trough (Chart 1). This rally occurred even as inflation data continued to surprise to the upside and employment data confirmed that the US labor market is extremely tight. With the economic data justifying the Fed’s hawkish pivot, the Treasury curve has flattened dramatically, and both the 2-year/10-year and 3-year/10-year slopes are now inverted (Chart 1, bottom panel). An inverted yield curve is a reliable late-cycle indicator, and we think current spread levels offer a good opportunity to reduce corporate bond exposure. This week, we downgrade investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5), placing the proceeds into Treasuries. We also downgrade our recommended allocations EM Sovereigns (see page 8) and TIPS (see page 11), upgrade our recommended allocation to CMBS (see page 13) and adjust our recommended yield curve positioning (see page 10). Feature Table 1Recommended Portfolio Specification The Beginning Of The End The Beginning Of The End Table 2Fixed Income Sector Performance The Beginning Of The End The Beginning Of The End Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 86 basis points in March, bringing year-to-date excess returns up to -154 bps. Our quality-adjusted 12-month breakeven spread shifted down to its 21st percentile since 1995 (Chart 2). As noted on the first page of this report, corporate spreads have rallied to within striking distance of their pre-COVID lows at the same time as the yield curve has become inverted beyond the 2-year maturity. We showed in last week’s report that an inversion of the 2-year/10-year Treasury slope is not necessarily a harbinger of imminent recession, but it does typically coincide with very low (and often negative) excess corporate bond returns.1 The combination of reasonably tight spreads and an inverted yield curve causes us to recommend downgrading investment grade corporate bond allocations from neutral (3 out of 5) to underweight (2 out of 5). It’s important to note that corporate balance sheets remain healthy (bottom panel) and we see no indication that a recession or default cycle will unfold during the next 6-12 months. That said, we must acknowledge that an inverted yield curve signals that the economic recovery is entering its late stages. Economic growth will be slower going forward and corporate spreads are unlikely to tighten much, especially from current depressed levels. Against this backdrop it makes sense to be more cautious on credit, sacrificing small positive excess returns in the near-term to ensure that we aren’t invested when the next downturn hits. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Beginning Of The End The Beginning Of The End Table 3BCorporate Sector Risk Vs. Reward* The Beginning Of The End The Beginning Of The End High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 119 basis points in March, bringing year-to-date excess returns up to -96 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – shifted down to 3.7% (Chart 3). An inverted yield curve sends the same negative signal for high-yield excess returns as it does for investment grade. However, high-yield valuation is currently more attractive. The option-adjusted spread differential between Ba-rated bonds and Baa-rated bonds remains elevated at 86 bps, 41 bps above its pre-COVID low (panel 3). It is also likely that economic growth will remain sufficiently strong for defaults to come in below the spread-implied threshold of 3.7% during the next 12 months (bottom panel). The greater attractiveness of high-yield valuations relative to investment grade causes us to maintain a higher allocation to the sector, even as we downgrade our portfolio’s overall credit risk exposure. We therefore recommend a neutral (3 out of 5) allocation to high-yield corporates.     MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -74 bps. The zero-volatility spread for conventional 30-year agency MBS tightened 3 bps on the month as a 4 bps tightening of the option-adjusted spread (OAS) was partially offset by a 1 bp increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.2 This valuation picture is starting to change. The option cost is now up to 40 bps, its highest level since 2016, and refi activity is slowing as the Fed lifts rates. At 28 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS.       Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to -505 bps. EM Sovereigns outperformed the Treasury benchmark by 40 bps on the month, bringing year-to-date excess returns up to -609 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 62 bps, dragging year-to-date excess returns down to -439 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 7 bps in March. This comes on the heels of a sharp underperformance in February that was driven by Russian bonds which have since been removed from the index. Russian bonds have also been purged from the EM Corporate & Quasi-Sovereign Index, and this index underperformed duration-matched US corporates by 11 bps in March (Chart 5). The yield differential between EM sovereigns and duration-matched US corporates remains negative. As such, we downgrade our recommended allocation to EM sovereigns from underweight (2 out of 5) to maximum underweight (1 out of 5). In sharp contrast, the EM Corporate & Quasi-Sovereign Index continuous to offer a significant yield advantage (panel 4). We retain our neutral (3 out of 5) recommendation for EM Corporates & Quasi-Sovereigns. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to -122 bps (before adjusting for the tax advantage). While the war in Ukraine has introduced a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past two months. The 10-year Aaa Muni / Treasury yield ratio is currently at 94%, up significantly from its 2021 trough of 55%. The yield ratios between 12-17 year munis and duration-matched corporate bonds are also up significantly off their lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 93%. The same measure for 17-year+ Revenue bonds stands at 101%, meaning that Revenue bonds carry a before-tax yield advantage versus duration-matched corporates. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve’s bear-flattening trend continued through March. The 2-year/10-year Treasury slope flattened 35 bps on the month and the 5-year/30-year Treasury slope flattened 44 bps. These slopes are now both inverted, sitting at -6 bps and -12 bps respectively. In last week’s report we noted the unusually wide divergence between very flat slopes at the long end of the yield curve and very steep slopes at the front end.3 For example, the 5-year/10-year Treasury slope is -18 bps but the 3-month/5-year slope is 204 bps. This divergence is happening because the market has moved quickly to price-in a rapid near-term pace of rate hikes that will end in roughly one year. However, so far, the Fed has only delivered 25 bps of those hikes and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced in the market but lasts longer, as is our expectation. By entering our new 5-year bullet over 2-year/10-year barbell trade we also close our previous 2-year bullet over cash/10-year barbell trade at a loss. We continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in March, bringing year-to-date excess returns up to +271 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 21 bps. Since last May we have been recommending that clients maintain a neutral allocation to TIPS versus nominal Treasuries at the long end of the curve and an underweight allocation to TIPS at the front end. This recommendation was premised on the view that the breakeven curve would steepen as falling inflation put downward pressure on short-maturity TIPS breakevens and long-dated breakevens remained at levels close to the Fed’s target. Recently, the 10-year TIPS breakeven inflation rate has shot up to levels well above the Fed’s 2.3%-2.5% target range (Chart 8) and our TIPS Breakeven Valuation Indictor has shifted into “expensive” territory (panel 2). Further, while inflation has remained high for longer than we expected, it still seems more likely than not that it will roll over between now and the end of the year as pandemic fears fade and consumers shift their spending patterns away from goods and toward services. As such, we think investors should take this opportunity to further reduce exposure to TIPS versus nominal Treasuries at both the short and long ends of the curve. That is, within our overall underweight allocation to TIPS we continue to recommend positioning in breakeven curve steepeners and in real yield curve flatteners. We also continue to recommend an outright short position in 2-year TIPS. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in March, dragging year-to-date excess returns down to -31 bps. Aaa-rated ABS underperformed by 21 bps on the month, dragging year-to-date excess returns down to -27 bps. Non-Aaa ABS underperformed by 49 bps on the month, dragging year-to-date excess returns down to -51 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in March, bringing year-to-date excess returns up to -78 bps. Aaa Non-Agency CMBS outperformed Treasuries by 25 bps on the month, bringing year-to-date excess returns up to -67 bps. Non-Aaa Non-Agency CMBS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -110 bps. CMBS spreads remain wide compared to other similarly risky spread products. Further, commercial real estate (CRE) lending standards have recently shifted into “net easing” territory and demand for CRE loans is strengthening (Chart 10). In light of today’s downgrade of corporate credit, non-agency CMBS look like an attractive alternative to add some spread to a portfolio. Increase exposure from neutral (3 out of 5) to overweight (4 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 17 basis points in March, dragging year-to-date excess returns down to -39 bps. The average index option-adjusted spread widened 5 bps on the month. It currently sits at 48 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 255 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Beginning Of The End The Beginning Of The End Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -55 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Beginning Of The End The Beginning Of The End Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of March 31, 2022) The Beginning Of The End The Beginning Of The End   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 2 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 3 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022.   Recommended Portfolio Specification The Beginning Of The End The Beginning Of The End Other Recommendations The Beginning Of The End The Beginning Of The End Treasury Index Returns Spread Product Returns

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 Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Listen to a short summary of this report.       Executive Summary Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively.  Tighter financial conditions augur badly for growth (see Chart).  We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious   Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Supply Chains Remain Disrupted Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Chart 6Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Will PMIs Fall Below 50? Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13).   Chart 11China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken European Data Starting To Weaken European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much.  Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Risks To Our View Chart 17Fed Feedback Loop Back In Action? Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending ...And So May Keep On Spending ...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months.     How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components.  Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3).   Chart 23AOPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries... ...Unlike Other Countries... ...Unlike Other Countries... Chart 23CTo Restore A Balanced But Tight Market To Restore A Balanced But Tight Market To Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price.   Chart 24Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound?  Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1).  Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3).  Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth.  As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US.   Global Economy Chart 25Global Growth Remains Robust... Global Growth Remains Robust... Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months.   Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system.  Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1).  In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2).  Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched.    Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation.   Corporate Bonds Chart 30Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis.   Commodities Chart 31Risks To Oil Price Are To The Upside Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4).   Currencies Chart 32Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months.   Alternatives Chart 33Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4).   Footnotes 1   Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary An inverted yield curve is a reliable recession indicator. Inversions of the 3-month/10-year Treasury slope and the 3-month/3-month, 18-months forward slope both provide more timely recession signals than inversion of the 2-year/10-year Treasury slope. An inverted yield curve is a reliable equity bear market indicator. Even when it’s not signaling a recession, the yield curve’s movements offer some insight into equity returns as stocks have consistently performed better while it is flattening than they have when it is steepening. The 2-year/10-year Treasury slope embeds useful information for corporate bond excess returns. Corporates perform best when the slope is very steep and worst when it is very flat and/or inverted. Treasury securities generally outperform cash when the yield curve is either very steep or inverted. The one exception is the early-1980s when the Fed continued to tighten aggressively even after an inversion of the yield curve. Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Bottom Line: The overall message from the yield curve is that, while the economic recovery is no longer in its early stages, it is premature to talk about a recession. On a 6-to-12 month investment horizon, investors should overweight equities in multi-asset portfolios. Within US bond portfolios, investors should maintain a neutral allocation to investment grade corporate bonds and keep portfolio duration close to benchmark. Feature It’s a well-known maxim in macro-finance that an inverted yield curve signals a recession. While that adage embeds a lot of truth, it is also sufficiently vague that it raises more questions than it answers. How far in advance does an inverted yield curve signal a recession? What specific yield curve segment sends the most helpful signal? And most importantly, does the yield curve tell us anything useful about the future performance of financial assets? These sorts of questions are particularly relevant today as we observe some sections of the yield curve approaching inversion while others make new highs (Chart 1). Chart 1Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals This Special Report explains how to think about the slope of the US Treasury curve as an indicator for the economy and financial markets. We first examine the yield curve’s empirical track record as a recession indicator. We then consider what the slope of the yield curve tells us about future equity, corporate bond and Treasury returns. The analysis presented in this report focuses on three different measures of the yield curve slope: The 2-year/10-year Treasury slope, the 3-month/10-year Treasury slope and the spread between the 3-month T-bill rate and the 3-month T-bill rate, 18 months forward. That last spread measure is less commonly cited, but Fed research has shown it to be a reliable predictor of recession.1 It was also recently highlighted by Fed Chair Jerome Powell.2 In the remainder of this report we will refer to the 3-month/3-month, 18-month forward spread as the “Fed Slope”. The Yield Curve & Recession Recession forecasting is a tricky business. It is often not so much a question of identifying “good” and “bad” recession indicators, but a question of balancing lead time and reliability. Recession indicators derived from financial market prices tend to offer greater advance warning of recession but also provide more false signals. On the flipside, indicators derived from macroeconomic data tend to give less lead time but with fewer false signals. Typically, the most useful recession indicators involve some combination of financial market and economic data. For example, a 2018 report from our US Investment Strategy service showed that a useful recession indicator can be created by combining the 3-month/10-year Treasury slope and the Conference Board’s Leading Economic Indicator.3 The Treasury slope’s reputation as an excellent recession indicator is justified because, despite it being derived from volatile financial market data, an inversion of the yield curve provides a very reliable recession signal. The 2-year/10-year Treasury slope has inverted in advance of 7 of the past 8 recessions and has not sent a false signal.4  The 3-month/10-year Treasury slope has done even better, calling 8 out of the past 8 recessions without a false signal. The Fed Slope, meanwhile, has also called 8 out of the past 8 recessions, but it sent one false signal in September 1998. There is room to quibble about the usefulness of the yield curve as a recession indicator in terms of lead time. The 2-year/10-year Treasury slope has, on average, inverted 15.9 months before the start of the next recession (Table 1). This inversion has always occurred before the first Fed rate cut of the cycle, and in all but one instance (1973-75), before the peak in the S&P 500. Table 1Lead Times For Yield Curve Segments, Equity Bear Markets And Fed Rate Cuts The Yield Curve As An Indicator The Yield Curve As An Indicator But while some advance warning is good, the 2-year/10-year slope probably gives too much lead time. For example, the 2-year/10-year slope inverted a full 24 months before the 2007-09 recession, but it would have been unwise to act on that information since the S&P 500 didn’t peak for another 22 months! The historical record shows that the 3-month/10-year Treasury curve and the Fed Slope offer more useful signals than the 2-year/10-year curve. On average, these curves provide less lead time than the 2-year/10-year slope but still generally provide advance warning of recession and stock market peaks. The recession signal from the 3-month/10-year slope has only missed the peak in the S&P 500 twice. The signal from the Fed Slope has only missed the stock market’s peak once, but it also sent one false signal. Synthesizing all this information, we conclude that the 3-month/10-year Treasury curve and the Fed Slope are both highly reliable recession indicators that typically provide more than enough advance warning for equity investors to adjust their positions. The main value of the 2-year/10-year Treasury curve is that its inversion warns that we may soon get a timelier signal from the 3-month/10-year Treasury slope and the Fed Slope. Looking at the present situation, the 2-year/10-year Treasury slope has flattened dramatically during the past few months, but at 18 bps it remains un-inverted. Meanwhile, the 3-month/10-year Treasury slope and the Fed Slope are both elevated at 195 bps and 255 bps, respectively. We can conclude from this that recession warnings are premature. We will become more concerned about an upcoming recession when the 3-month/10-year slope and the Fed Slope approach inversion. The Yield Curve & Equity Returns Identifying a recession and demarcating its beginning and ending dates may seem like a trivial exercise that has little practical import. Celebrated mutual fund manager Peter Lynch has repeatedly offered the opinion that any time an equity investor spends thinking about the economy is wasted time. We beg to differ. Equity bear markets reliably coincide with recessions (Chart 2) – since the late 1960s, only one recession has occurred without a bear market (the first leg of the Volcker double dip from January to July 1980) and only one bear market has occurred without a recession (October 1987’s Black Monday bear market) – and an asset allocator who reduced equity exposure upon receiving advance notice of recessions would have been in a position to generate significant alpha. Chart 2Recessions And Bear Markets Tend To Coincide Recessions And Bear Markets Tend To Coincide Recessions And Bear Markets Tend To Coincide The relationship between equity returns and the business cycle is not happenstance – variation in stock prices correlates closely with variation in corporate earnings and corporate earnings growth is a function of the business cycle. Equity prices, P, are simply the product of earnings per share, E, and the multiple investors are willing to pay for them, P/E: P = E x (P/E). If we hold somewhat fickle P/E multiples constant, stock prices will rise and fall with earnings. Given that earnings rarely decline outside of recessions (Chart 3), investors can expect equities to rise during expansions and decline during recessions. Chart 3Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Digging a little more deeply into the empirical record since consensus S&P 500 earnings estimates began to be compiled reinforces the earnings/returns link. With the exception of the first leg of the Volcker double dip recession in 1980, forward four-quarter earnings estimates have fallen in every recession and have contracted in the aggregate at an annualized 16% rate (Table 2). Multiples have expanded at a hearty 9% clip from the beginning to the end of recessions but have always declined, sometimes sharply, during them. Conversely, earnings estimates always grow heartily during expansions, while multiples tend to observe a fairly tight range. Multiples and stocks move ahead of the business cycle, consistently troughing before the end of a recession, but the 20-percentage-point expansion/recession disparity in annualized returns testifies to the yield curve’s utility as an investment leading indicator. Table 2When Earnings Fall, So Do Stocks The Yield Curve As An Indicator The Yield Curve As An Indicator The yield curve’s usefulness as a predictor of equity returns goes beyond recession signaling. Over the last half-century, the yield curve has tended to steepen and flatten in distinct phases. Defining a phase as a move of at least 200 basis points (bps) between the 3-month/10-year curve slope’s peak and trough, we count ten steepenings and nine flattenings since August 1969 (Chart 4). Chart 450 Years Of Steepening And Flattening 50 Years Of Steepening And Flattening 50 Years Of Steepening And Flattening After segmenting performance by slope increments in steepening (Table 3, top panel) and flattening (Table 3, middle panel) phases, we find a clear distinction. S&P 500 total returns tend to be much stronger when the yield curve is in a flattening phase than when it is steepening. In general, a steeper curve is better than a flatter (or inverted) one for equity returns but flattening dominates steepening in every segment but the current one (150-200 bps). The cheery news for investors concerned about an inverted yield curve’s effect on stocks is that the upcoming flattening increments between now and inversion have historically been favorable. Though we are tactically neutral equities, we recommend overweighting them in multi-asset portfolios over a cyclical 6-to-12 month timeframe. Table 3Stocks Like A Flattening Yield Curve The Yield Curve As An Indicator The Yield Curve As An Indicator The Yield Curve & Corporate Bond Returns This section of the report considers investment grade corporate bond returns in excess of a duration-matched position in US Treasuries and whether the slope of the Treasury curve can help us predict their magnitude. First, it’s important to point out that there is a lot of overlap between excess corporate bond returns and equity returns, but it is not complete (Chart 5). Corporates certainly tend to underperform duration-matched Treasuries during recessions and equity bear markets, but there have also been significant bouts of underperformance that fall outside of those periods. For example, corporate bond returns peaked well before equity returns in the late-1990s and corporates also underwent a severe selloff in 2014-15. Chart 5Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend That said, Table 4 shows that, as is the case with stocks, a strategy of reducing corporate bond exposure during recessions will profit over time. Corporate bonds have underperformed Treasuries by a cumulative 3.1% (annualized) during recessions since 1979 and have outperformed by 1.2% (annualized) in non-recessionary periods. Table 4Corporate Bond Performance In And Out Of Recessions The Yield Curve As An Indicator The Yield Curve As An Indicator The results in Table 4 suggest that investors should remain overweight corporate bonds versus Treasuries at least until the 3-month/10-year Treasury slope inverts. However, we think investors can perform even better if they pay attention to early warning signs from the 2-year/10-year Treasury slope. Table 5 shows historic 12-month corporate bond excess returns given different starting points for the 2-year/10-year slope. The starting points are also split depending on whether the 2-year/10-year slope was in a steepening or flattening trend at the time. Table 512-Month Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend The Yield Curve As An Indicator The Yield Curve As An Indicator The results presented in Table 5 show that the level of the slope matters much more than whether the curve is in a steepening or flattening trend. They also show that, in general, excess returns tend to be much higher when the slope is steep than when it is flat. We also see that the odds of corporate bonds outperforming duration-matched Treasuries on a 12-month horizon decline markedly for periods when the 2-year/10-year slope starts below 25 bps. At present, the 2-year/10-year Treasury slope is 18 bps, just below the 25-bps cutoff. Though we take this negative signal from the yield curve seriously, we also anticipate that peaking inflation will prevent the Fed from raising rates by 245 bps during the next 12 months, the pace that is currently discounted in the yield curve. If this view pans out it will likely lead to some modest 2/10 curve steepening and a relief rally in corporate spreads. To square the difference between the current negative message from the yield curve and our more optimistic macro view, we recommend a neutral allocation to investment grade corporate bonds within US fixed income portfolios. Though we will likely downgrade our recommended allocation if the 2-year/10-year slope continues to flatten and approaches inversion. The Yield Curve & Treasury Returns This section of the report considers US Treasury index returns in excess of a position in cash, a metric designed to proxy for the returns earned by varying a US bond portfolio’s average duration. Treasury outperformance of cash indicates that long duration positions are profiting while Treasury underperformance of cash indicates that short duration positions are in the green. The historical relationship between Treasury returns and the slope of the yield curve is heavily influenced by the early-1980s period when the Fed plunged the economy into a double-dip recession to contain spiraling inflation. Chart 6 shows that this early-1980s episode is the only one where Treasuries sold off steeply even after all three of our yield curves had inverted. Chart 6A Repeat Of The Early 1980s Episode Remains Unlikely A Repeat Of The Early 1980s Episode Remains Unlikely A Repeat Of The Early 1980s Episode Remains Unlikely In fact, if we look at the history of 12-month Treasury returns going back to 1973 split by the starting point for the slope (Tables 6A, 6B & 6C), we see that returns are worst after the curve is inverted and best when the curve is very steep. Table 6A12-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Slope Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 6B12-Month Treasury Excess Returns* Given Different Starting Points For 3-Month / 10-Year Slope Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 6C12-Month Treasury Excess Returns* Given Different Starting Points For the Fed Slope** Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator However, that picture changes if we start our historical sample in 1985 to exclude the early-1980s episode. Now, we see that Treasury returns tend to be high when the yield curve is very steep and when it is inverted (Tables 7A, 7B & 7C). The worst 12-month periods for Treasury returns are when the 2-year/10-year slope is between 75 bps and 100 bps, when the 3-month/10-year slope is between 50 bps and 75 bps and when the Fed Curve is between 0 bps and 25 bps. If we apply today’s situation to the post-1985 results shown in Tables 7A, 7B & 7C, we would conclude that the outlook for Treasury returns is very positive. The 3-month/10-year slope and Fed Curve are very steep, and the 2-year/10-year slope is in the 0 bps to 25 bps range. Of course, that message from the 2-year/10-year slope flips if viewed in the context of the post-1973 data shown in Table 6A. Table 7A12-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Slope Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 7B12-Month Treasury Excess Returns* Given Different Starting Points For 3-Month / 10-Year Slope Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 7C12-Month Treasury Excess Returns* Given Different Starting Points For the Fed Slope** Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Our assessment is that the risk of a repeat of the early-1980s episode is still relatively small. Yes, inflation is extremely high, but it is likely to moderate naturally as we gain more distance from the pandemic. In that environment, the Fed will not feel the need to continue tightening aggressively even after all three segments of the yield curve have inverted. As such, we are inclined to view the message from the yield curve as positive for Treasury returns on a 12-month horizon, and we continue to advocate keeping average bond portfolio duration “at benchmark”.   Ryan Swift US Bond Strategist rswift@bcaresearch.com   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-20180628.htm 2 https://www.bloomberg.com/news/articles/2022-03-21/powell-says-look-at-short-term-yield-curve-for-recession-risk?sref=Ij5V3tFi 3 Please see US Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?”, dated August 13, 2018. 4 We define an instance of “inversion” as a yield curve slope below zero for two consecutive months. Treasury Index Returns Spread Product Returns

Executive Summary Tracking Inflation In 2022 Tracking Inflation In 2022 Tracking Inflation In 2022 Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). A 50 bps rate hike is possible at some point this year, but only if long-maturity inflation expectations become un-anchored or core PCE inflation prints consistently above 0.30%-0.35% per month. Historical evidence suggests that Treasury securities perform best when the yield curve is very steep or very flat. All else equal, an inversion of the 2-year/10-year Treasury slope would make us more bullish on bonds. High-yield corporates have performed better than investment grade corporates during the recent sell-off. Investors should continue to favor high-yield corporates over investment grade. Bottom Line: Investors should maintain “at benchmark” portfolio duration and buy Treasury curve steepeners. We also maintain an overweight allocation to high-yield corporate bonds and a neutral allocation to investment grade corporates. We Have Liftoff The Fed followed through on its earlier promise and lifted the funds rate by 25 basis points last week. FOMC participants also sharply revised up their expectations for the future pace of tightening, though this revision mostly just made the Fed’s forecast more consistent with what was already priced in the yield curve. Market rate hike expectations, as inferred from the overnight index swap curve, shifted up only slightly after the Fed’s announcement (Chart 1). Chart 1Rate Expectations Rate Expectations Rate Expectations As of Monday morning, the bond market is priced for 208 bps of tightening during the next 12 months and 174 bps between now and the end of the year. This is close to the median FOMC forecast which calls for 150 bps of further tightening this year followed by an additional 92 bps in 2023. Last week’s report highlighted the tricky situation faced by the Fed.1 On the one hand, the Fed must tighten quickly enough to keep long-dated inflation expectations anchored. On the other hand, the Fed wants to avoid tightening so quickly that it causes a recession. For investors, we think it makes sense to assume that the Fed will try to split the difference by lifting rates at a pace of 25 bps per meeting for at least the next 12 months. However, there are significant risks to both the upside and downside of this projection. The Odds Of A 50 bps Hike The upside risk is that inflation is sufficiently sticky that the Fed will feel the need to deliver a 50 bps rate hike at some point this year. Last week’s Fed interest rate projections show that 7 out of 16 FOMC participants think that at least one 50 bps rate hike will be necessary. Meanwhile, market prices are consistent with one 50 basis point rate hike and five 25 basis point rate hikes at this year’s six remaining FOMC meetings. We think the Fed will only deliver a 50 bps rate hike if inflation looks to be tracking above the committee’s 2022 forecast or if long-maturity inflation expectations become un-anchored to the upside. Related Report  Global Investment StrategyIs A Higher Neutral Rate Good Or Bad For Stocks? On the inflation front, the FOMC’s central tendency forecast calls for core PCE inflation of between 3.9% and 4.4% in 2022, with a median of 4.1%. To match this forecast, core PCE will have to average a monthly growth rate of between 0.30% and 0.35% in each of this year’s eleven remaining months (Chart 2).2 Every monthly inflation print above that range increases the odds of a 50 bps Fed move, every print below that range brings the odds down. As for long-maturity inflation expectations, the Fed likely views them as “well anchored” for the time being. The 10-year TIPS breakeven inflation rate has broken meaningfully above the Fed’s target range but the 5-year/5-year forward TIPS breakeven inflation rate remains consistent with the Fed’s goals (Chart 3). The University of Michigan’s survey measure of 5-10 year household inflation expectations has risen sharply, but it has not yet broken meaningfully above recent historical levels (Chart 3, bottom panel). Chart 2Tracking Inflation In 2022 Tracking Inflation In 2022 Tracking Inflation In 2022 Chart 3Inflation Expectations Inflation Expectations Inflation Expectations Our sense is that inflation is very close to peaking and that lower inflation in the back half of the year will apply downward pressure to inflation expectations and prevent the Fed from delivering a 50 bps hike at any single FOMC meeting. However, we will be closely tracking the evolution of Charts 2 and 3 to see if this situation changes. The Odds Of Skipping A Meeting Chart 4Financial Conditions Financial Conditions Financial Conditions The downside risk to the Fed’s expected rate hike path results from the fact that financial conditions have already responded aggressively to the Fed’s actions and communications. While it’s certainly true that financial conditions remain extremely accommodative in level terms (Chart 4), we must also acknowledge that, historically, the sort of rapid tightening of financial conditions that we have already seen is almost always followed by a significant slowdown in economic activity (Chart 4, panel 2). On top of all that, the yield curve is now completely flat beyond the 5-year maturity point and the 2-year/10-year Treasury slope is a mere 22 bps away from inversion (Chart 4, bottom panel). The Fed’s new interest rate projections show the median expected interest rate moving above estimates of the long-run neutral rate in 2023 and 2024. This sort of rate hike path is consistent with a mild inversion of the yield curve, and the Fed will likely downplay the yield curve’s recession signal during the next few months. That said, a deepening inversion of the yield curve will only increase market worries about an over-tightening of monetary policy. This could lead to a sell-off in risk assets that would accelerate the tightening of financial conditions and lead to expectations of even slower economic growth. The next section of this report explores what an inverted 2-year/10-year yield curve has historically meant for Treasury returns. Investment Implications Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). We also see economic growth slowing but remaining solid enough to prevent a significant sell-off in risk assets and a deep inversion of the yield curve. We also acknowledge, however, that the risks to this view (in both directions) are unusually high. Given all that, our recommended investment strategy is to keep portfolio duration close to benchmark. The market is already well priced for a steady 25 bps per meeting pace of tightening and bond yields will merely keep pace with forwards if that pace is delivered. We also see yield curve steepeners profiting during the next 6-12 months as the yield curve’s flattening trend takes a pause now that market expectations have fully adjusted to the likely path of Fed rate increases. We remain neutral TIPS versus nominal Treasuries at the long-end of the curve, but underweight TIPS versus nominal Treasuries at the front-end. Short-maturity TIPS will underperform as inflation moderates in H2 2022. The Yield Curve And Treasury Returns The historical relationship between the slope of the yield curve and Treasury returns is very interesting. To examine it, we first looked at historical data on excess Treasury index returns versus cash since 1989 (Table 1). Table 112-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Treasury Slope The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Specifically, we show 12-month excess Treasury returns given different starting points for the 2-year/10-year Treasury slope. For example, when the 2-year/10-year Treasury slope has been between 0 bps and 25 bps, the Bloomberg Barclays Treasury Index has historically outperformed a position in cash by an average of 2.75% during the next 12 months. A 90% confidence interval places expected returns between 1.75% and 3.73%, and excess Treasury returns were positive in 73% of historical observations. The first big conclusion that jumps out from Table 1 is that Treasuries perform best when the yield curve is either very steep or very flat. The worst periods for Treasury returns have tended to occur when the slope is between 25 bps and 100 bps. It’s easy to understand why a very steep yield curve would lead to strong Treasury returns. A steep curve means that Treasuries offer a large yield advantage versus cash, or put differently, an extremely rapid pace of rate hikes would be necessary for cash returns to overcome the carry advantage in bonds. It’s more difficult to understand why Treasury returns have been strong after instances of curve inversion. The most likely reason is that market participants have tended to overestimate the odds of the Fed achieving a “soft landing” and have underestimated the odds of an upcoming recession and rate cuts. The data used in Table 1 are limited in that observations only begin in 1989. As such, the table misses the Paul Volcker period of the early 1980s when Treasuries continued to sell off well after the curve inverted. Chart 5 extends the historical period back to the mid-1970s and uses shading to indicate periods of 2-year/10-year yield curve inversion. Chart 5Yields Tend To Peak Shortly After Curve Inversion Yields Tend To Peak Shortly After Curve Inversion Yields Tend To Peak Shortly After Curve Inversion Chart 5 reveals a pretty clear pattern. With the exception of the late-1970s/early-1980s episode, the 10-year Treasury yield tends to peak right around the time of 2-year/10-year yield curve inversion, or shortly after in the case of 1989. What can we take away from this analysis? First, the evidence suggests that we should have a bias toward taking more duration risk in our portfolio if and when the yield curve inverts. A more deeply inverted yield curve should also be viewed as a stronger bond-bullish signal than a modestly inverted yield curve. Second, we must acknowledge the major risk to this strategy. Specifically, the risk that inflation will be so high that the Fed will continue to tighten aggressively even after the yield curve inverts, as Paul Volcker did in the early-1980s. Our sense is that the odds of a repeat “Volcker moment” are low. Inflation will naturally fall as the pandemic’s impact wanes and the Fed won’t be forced to deliver another hawkish shock to market expectations. Therefore, we maintain our “at benchmark” recommendation for portfolio duration for now, but we may turn more bullish on bonds if the yield curve inverts. The Poor Performance Of Investment Grade Bonds Chart 6IG Has Lagged HY IG Has Lagged HY IG Has Lagged HY One notable aspect of recent bond market moves has been that the performance of investment grade corporate bonds has significantly lagged the performance of high-yield corporate bonds during the recent period of spread widening (Chart 6). This is highly unusual. Typically, we expect bonds with more credit risk to behave like “higher beta” securities. That is, we expect lower-rated bonds to perform better in bull markets and worse in bear markets.3 The typical relationships held earlier in the cycle. Chart 7A shows that high-yield corporate bonds delivered stronger excess returns than investment grade corporate bonds from the March 2020 peak in spreads through the end of that year. Chart 7B shows that high-yield continued to outperform investment grade throughout the bull market for spreads in 2021. Chart 7ACorporate Bond Excess Returns* Versus DTS: March 2020 To December 2020 The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Chart 7BCorporate Bond Excess Returns* Versus DTS: January 2021 To September 2021 The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Chart 7CCorporate Bond Excess Returns* Versus DTS: September 2021 To Present The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Based on that relationship, we would expect high-yield to perform worse than investment grade since spreads troughed in September 2021, but that has not been the case (Chart 7C). How do we explain the relatively weak performance of investment grade corporates relative to high-yield? One possible explanation is that the industry composition of the investment grade and high-yield bond universes is different. High-yield has a large concentration in the Energy sector while investment grade is more geared toward Financials. Given the recent surge in oil prices, it’s possible that the strong performance of Energy credits is driving the return divergence between investment grade and high-yield. Chart 8 shows the performance of each individual industry group within both investment grade and high-yield since the September 2021 trough in spreads. It shows that Energy bond returns have indeed been stronger than for other sectors. In fact, high-yield Energy excess returns have been positive! Chart 8Corporate Bond Excess Returns* Versus DTS: September 2021 To Present The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion However, Chart 8 mainly reveals that industry composition only explains part of the divergence between investment grade and high-yield returns. Notice that every single high-yield industry group has outperformed its investment grade counterpart since September 2021. This suggests that there is a more fundamental reason for the divergence between investment grade and high-yield performance. Chart 9Following The 2018 Roadmap Following The 2018 Roadmap Following The 2018 Roadmap Our own sense is that the corporate bond market is following the roadmap from early 2018 (Chart 9). At that time, Fed tightening pushed the Treasury slope below 50 bps and investment grade corporates started to perform poorly, presumably because the removal of monetary accommodation justified somewhat wider corporate bond spreads. However, high-yield performed well in early 2018 as there was no material increase in corporate default risk, even though the Fed was tightening. A similar market narrative could easily be applied to today. Back in 2018, the market narrative shifted late in the year when investors suddenly decided that Fed tightening had gone too far. High-Yield sold off sharply and caught up with investment grade. The Fed was then forced to end its tightening cycle and corporate bonds rallied in early 2019. We see this 2018 roadmap as a significant risk, but not destiny. While there’s a chance that the market will soon decide that the Fed has over-tightened, leading to a sharp sell-off in high-yield. There’s also a chance that gradual Fed rate hikes will continue for much longer than the market anticipates without meaningfully slowing the economy. In that case, high-yield returns would remain solid for some time and the recent spread widening in investment grade would probably abate. For the time being, we find ourselves more inclined toward the latter scenario. Bottom Line: Investors should maintain an overweight allocation to high-yield and a neutral allocation to investment grade corporate bonds within a US bond portfolio. We may soon get a chance to upgrade our corporate bond allocation if inflationary pressures abate and the war in Ukraine shows signs of de-escalation. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 PCE data is so far only updated to January 2022. 3 In this report we use Duration-Times-Spread (DTS) as a simple measure of a bond index’s credit risk. A higher DTS means that a bond has greater credit risk and vice-versa. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Other Recommendations The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion