Corporate Bonds

Executive Summary European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Corporate bond spreads in the US and Europe have widened since early April, with European credit taking a bigger hit because of worsening growth and inflation momentum. European corporate bond valuations look fairly cheap, both for investment grade and high-yield.  This is true in absolute terms but also relative to the US, where spread valuations are more mixed.  An easing of stagflation fears in Europe is a necessary condition for a valuation convergence with the US. The US investment grade credit curve is steep relative to the overall level of credit spreads, making longer-maturity corporates more attractive. Energy bonds offer the most compelling combination of valuation and fundamental support (from high oil prices) within US investment grade. Within US high-yield, Energy valuations look much less compelling after the recent outperformance. The best medium-term industry values in European credit are in investment grade Financials and high-yield Consumer Cyclicals & Non-Cyclicals. Bottom Line: Continue to favor both US high-yield and European investment grade corporates versus US investment grade.  Stay neutral high-yield exposure on both sides of the Atlantic.  Within Europe, stay up in quality within both investment grade and high-yield until near-term macro risks on growth & inflation subside. Feature Corporate bonds in the US and Europe have gone through a rough patch in recent weeks, underperforming government bonds in response to the “triple threat” of high inflation, tightening monetary policy and slowing growth momentum.  European credit has taken the more severe hit compared to the US, with markets pricing in greater risk premia because of additional regional threats to growth (and inflation) from the Ukraine war. In this Special Report, jointly presented by BCA Research US Bond Strategy and Global Fixed Income Strategy, we assess credit spread valuations in US and European corporates after the latest selloff, across credit tiers, maturities and industry groups.  Stay Cautious On US Corporate Bonds Chart 1US Credit Spreads US Credit Spreads US Credit Spreads In a recent Special Report, we argued in favor of a relatively defensive allocation to US corporate bonds. Specifically, we advised investors to adopt an underweight (2 out of 5) allocation to US investment grade corporates and a neutral (3 out of 5) allocation to US high-yield. Our rationale was that a flat US Treasury curve signaled that we were in the middle-to-late stages of the economic recovery. Additionally, at the time, corporate bond spreads weren’t all that attractive compared to the average levels seen during the last Fed tightening cycle (Chart 1). Spreads have widened somewhat since we downgraded our allocation and, as such, we see some scope for spread tightening during the next few months as inflation rolls over and the Fed lifts rates by no more than what is already priced in the curve. That said, with the Fed in the midst of a tightening cycle, we think it’s unlikely that spreads can stay below average 2017-19 levels for any meaningful length of time. As a result, we maintain our current cautious allocation to US corporate bonds. US High-Yield Versus US Investment Grade The recent period of US corporate bond underperformance can be split into two stages based on the relative performance of investment grade and high-yield. US investment grade underperformed junk in the early stages of the selloff (between September and mid-March), as spread widening was driven by the Fed’s shift toward a more restrictive policy stance and not a meaningful uptick in the perceived risk of a recession and/or default wave (Chart 2A). Chart 2ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff But recession and default fears started to ramp up in mid-March, and this caused high-yield to join the selloff (Chart 2B). In fact, US investment grade corporates managed to recoup some of their earlier losses while lower-rated junk bonds struggled to keep pace. Chart 2BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff We contend that the risk of a meaningful uptick in corporate defaults during the next 12 months is low. In fact, we estimate that the US high-yield default rate will fall to between 2.7% and 3.7% during the next year, well below the 5.2% currently priced into junk spreads. Going forward, we expect the US corporate bond landscape to be defined by increasingly restrictive monetary policy and a benign default outlook. As we noted in the aforementioned Special Report, this environment is reminiscent of the 2004-06 Fed tightening cycle when high-yield bonds performed much better than investment grade. Investors should maintain a preference for high-yield over investment grade within an otherwise defensive allocation to US corporate bonds. US Industry Groups Chart 3A shows the performance of US corporate bonds in the early stages of the recent selloff, but this time split by industry group. High-yield Energy sticks out as a strong outperformer, though we also notice that every high-yield sector performed better than its investment grade counterpart. Chart 3ACorporate Bond Excess Returns* Versus Duration-Times-Spread: September 27, 2021 To March 14, 2022 Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 3B once again shows how the relative performance between investment grade and high-yield has flipped since mid-March, though we see that high-yield Energy, Transportation and Utilities have performed better than the rest of the index.  Chart 3BCorporate Bond Excess Returns* Versus Duration-Times-Spread: March 14, 2022 To Present Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Interestingly, despite the strong outperformance of high-yield Energy bonds, investment grade Energy credits performed mostly in line with other investment grade sectors. We believe this presents an excellent opportunity.  The vertical axis of Chart 4A shows our measure of the risk-adjusted spread available in each investment grade industry group. Our risk-adjusted spread is the residual after adjusting for each sector’s credit rating and duration. The horizontal axis shows each sector’s Duration-Times-Spread as a simple measure of risk. Our model shows that Financials, Technology, Energy, Utilities, Communications and Basic Industry all stand out as attractive within the investment grade corporate bond universe. We identify the investment grade Energy sector as a particularly compelling buy. Chart 4AUS Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff In a prior report, we demonstrated, unsurprisingly, that the oil price is an important determinant of whether Energy bonds perform better or worse than the rest of the corporate index. With our commodity strategists calling for the Brent crude oil price to average $122/bbl next year, this will provide strong support to Energy bond returns. Cheap starting valuations for investment grade Energy bonds make them look even more compelling. Chart 4B repeats our valuation exercise but for high-yield industry groups. Within high-yield, we find that Financials, Transportation, Communications and Consumer sectors stand out as attractive. Interestingly, high-yield Energy bonds now look slightly expensive compared to the rest of the junk bond universe, a result of the sector’s recent incredibly strong performance. Chart 4BUS High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff US Credit Curve We define the credit curve as the difference in option-adjusted spread between the “Long Maturity” and “Intermediate Maturity” sub-indexes for each investment grade credit tier, as defined by Bloomberg. We exclude high-yield from this analysis because very few high-yield bonds are classified as “Long Maturity”. To analyze the credit curve, we observe that credit curves tend to be steeper when credit spreads are tight, and vice-versa. This is because tight spreads indicate that the perceived near-term risk of default is low. As a result, short-maturity spreads tend to be lower than spreads at the long-end of the curve. Conversely, a wide spread environment indicates that the perceived near-term risk of default is high, and this risk will be more reflected in shorter maturity credits. Charts 5A, 5B and 5C show the slopes of the credit curves for Aa, A and Baa-rated securities. Immediately we notice that credit curves are positively sloped in each case, and also that each credit curve is somewhat steeper than would be predicted based on the average spread for the overall credit tier. Chart 5AAa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5BA-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 5CBaa-Rated Credit Curve Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff This strongly suggests that investors should favor long-maturity over short-maturity US investment grade corporate bonds. European Corporates Look Cheap Vs. US Equivalents – For Patient Investors Chart 6European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks European Credit Spreads At Past 'Non-Crisis' Peaks Turning to the euro area, the Bloomberg investment grade OAS and high-yield OAS currently sit at 167bps and 490bps, respectively (Chart 6). These levels are well below the peaks seen during the 2020 COVID recession and the 2011/12 European debt crisis, but are in line with the spread widening episodes in 2014/15 and 2018. Our preferred measure of credit spread valuation, 12-month breakeven spreads, show that European investment grade and high-yield spreads are in the 75th and 67th percentile of outcomes, respectively, dating back to the inception of the euro in 1998 (Chart 7).1 These are both higher compared to the breakeven percentile rankings for US investment grade (48%) and US high-yield (52%). The gap between the breakeven percentile rankings for investment grade bonds in the euro area versus the US is the widest seen over the past two decades.  That gap reflects the fact that European economic growth has softened versus the US according to the S&P Global manufacturing PMIs, while European inflation has accelerated towards very elevated US levels (Chart 8).  Chart 7European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads European Spreads Have Cheapened Up More Than US Spreads Chart 8European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation European Corporate Underperformance Reflects Relative Growth & Inflation Both of those trends are a product of the Ukraine war, which has led to a massive spike in European energy costs given the region's huge reliance on Russian energy supplies, particularly for natural gas. While the US has also suffered a massive increase in its own energy bills, the inflation spike has been higher in Europe, leading to a bigger drag on economic confidence and growth. Thus, the widening spread differential between corporate bonds in Europe relative to the US likely reflects a growth-related risk premium. Chart 9A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? A Turning Point For European Corporate Bond Performance? As euro area inflation has ratcheted higher, so have expectations of ECB monetary tightening. The euro area overnight index swap (OIS) curve now discounts 172bps over the next 12 months, a huge swing from the start of 2022 when markets were expecting the European Central Bank (ECB) to stand pat on the interest rate front. In comparison, markets are pricing in another 224bps of Fed tightening over the next 12 months, even after the Fed has already delivered 75bps of tightening since March. Importantly, the gap between our 12-month discounters, which measure one-year-ahead interest rate changes discounted into OIS curves, for the US and Europe has proven to be a reliable leading indicator – by around nine months - of the relative year-over-year excess returns (on a USD-hedged basis) of European and US corporate bonds, especially for investment grade (Chart 9). The fact that this is a leading relationship suggests that the upward repricing of ECB rate expectations seen so far in 2022 is not yet a reason to turn more cyclically negative on European corporate bonds versus the US. The earlier upward repricing of expected Fed tightening is the more relevant factor, and is signaling that both US investment grade and high-yield corporates should underperform European equivalents over at least the rest of 2022.  BCA Research Global Fixed Income Strategy already has a recommended allocation along those lines, with an overweight to euro area investment grade and an underweight to US investment grade. While the trade has underperformed of late, the combined messages from the relative 12-month breakeven spread rankings (cheaper European valuations) and 12-month discounters (the Fed is further ahead in the tightening cycle) leads us to stick with that relative cross-Atlantic tilt. The main risk to that stance is any deterioration of the flow of energy supplies from Russia to Europe that results in a stagflationary outcome of a bigger growth slowdown with even faster inflation. That is a scenario that would make it difficult for the ECB to back down from its recent hawkish forward guidance, resulting in European corporate spreads incorporating an even wider risk premium.  Given that near-term uncertainty, we are advocating that investors maintain no relative tilt on more growth-sensitive, and riskier, European high-yield relative to the US – stay neutral on both. Stay Up In Quality On European Corporates Looking at euro area corporate debt across credit ratings and maturity buckets, there are few compelling immediate valuation stories in absolute terms, although there are potential opportunities unfolding on a relative basis.  Within investment grade, credit quality curves have steepened during the recent selloff, with lower-rated credit seeing larger spread widening (Chart 10). The gap between Baa-rated and A-rated European corporate spreads now sits at 52bps, right in the middle of the 25-75bps range since 2014. In high-yield, the gap between Ba-rated and B-rated credit spreads is 222bps, and the gap between B-rated and Caa-rated spreads is 370bps (Chart 11) – both are still below the previous peaks in those relationships seen in 2012, 2015 and 2020. Chart 10European IG Credit Quality Curve Can Steepen ##br##More European IG Credit Quality Curve Can Steepen More European IG Credit Quality Curve Can Steepen More Chart 11European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks European HY Credit Quality Curve Still Below Previous Peaks For both investment grade and high-yield, there is still room for credit curves to steepen if European growth expectations continue to deteriorate. However, when looking at spread valuations across the credit quality spectrum, and across maturity buckets, euro area corporate spreads look much cheaper than US equivalents. In Chart 12, we show a snapshot of the current 12-month breakeven percentile rankings for individual credit quality tiers and maturity groups, for investment grade and high-yield in the euro area and US.  The relative attractiveness of European credit relative to the US is evident, with European spreads now at higher percentile rankings across all quality tiers and maturity buckets. The largest gaps between 12-month breakeven percentile rankings are in the +10 year maturity bucket, the AAA-rated and AA-rated investment grade credit tiers, and the Ba-rated high-yield credit tier. This suggests any trades favoring European corporates versus the US should stay up in credit quality. Chart 12Corporate Spread Valuations By Maturity & Credit Rating Favor Europe Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Comparing European & US Industry Spread Valuations When looking at the industry composition of the euro area and US corporate bond indices, there are a few major notable differences. Within investment grade, there is a greater concentration of Energy and Technology names in the US, while Financials are more represented in the European index (Chart 13).  Those same three industries also have the largest relative weightings in the high-yield indices (Chart 14), although there is also a slightly larger weighting of high-yield Transportation companies in Europe compared to the US.  This means that a bet on European credit versus the US is essentially a bet on European Financials versus US Energy and Technology. Chart 13Investment Grade Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Chart 14High-Yield Corporate Bond Market Cap Weights Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff When looking at the same sector metrics that were shown earlier in this report for the US – comparing risk-adjusted spreads to Duration-Times-Spread – we find some interesting cross-Atlantic valuation differentials. For investment grade in Europe (Chart 15), only Energy and Financials have positive risk-adjusted spread valuations (after controlling for duration and credit quality), while having the highest level of risk expressed via Duration-Times-Spread. This contrasts to the US where more sectors have positive risk-adjusted spreads - Energy, Financials, Utilities, Basic Industry and Communications. Investors should favor the latter three industries in the US relative to Europe. Chart 15Euro Area Investment Grade Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Within high-yield in Europe, Energy and Financials also offer positive risk-adjusted valuations, but so do Consumer Cyclicals and Consumer Non-Cyclicals (Chart 16). This lines up similarly to US high-yield valuations. The notable valuation gaps exist in Transportation and Communications, which look cheap in the US and expensive in Europe, creating potential cross-Atlantic relative value trade opportunities between those sectors (and within an overall neutral allocation to junk in both regions). Chart 16Euro Area High-Yield Corporate Sector Valuation Looking For Opportunities In US & European Corporates After The Recent Selloff Looking For Opportunities In US & European Corporates After The Recent Selloff Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 12-month breakeven spreads measure the amount of spread widening that would be necessary to make the return on corporate bonds equal to that of duration-matched government bonds over a one-year horizon.  The spread is calculated as a ratio of the index OAS and index duration for the relevant credit market. We look at the historical percentile ranking of that ratio to make a more “apples for apples” comparison of spreads that factors in index duration changes over time. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Inflationary Pressures To Fade Inflationary Pressures To Fade Inflationary Pressures To Fade The biggest problem for the European economy is surging inflation. Inflation has eroded household real disposable income and is hurting consumption. Inflation is set to roll over this summer, which should allow European economies to begin recovering in the fourth quarter of 2022. The ECB is likely to pause after exiting negative interest rates in Q3. European credit is becoming more attractive, but the risks to our view of European growth could still cause major problems for this asset class. Swiss stocks are vulnerable to a pullback relative to German ones. In France, President Emmanuel Macron is likely to get a legislative majority in June.     Bottom Line: European growth should recover after inflation rolls over this summer. The peak in inflation will allow the ECB to pause after its deposit rate gets to zero. Despite this positive view, the large risks hanging over Europe suggest prudence is still warranted.   European assets are rebounding in conjunction with the decline in risk aversion visible around global markets. The euro is catching a welcome bid too. However, as we wrote last week, while the conditions are falling in place to see a rally in Europe, too many risks continue to lurk in the background.  Therefore, we maintain our conservative approach to European markets, and we still recommend a defensive portfolio. Related Report  European Investment StrategyDon’t Be A Hero To shift to a less defensive stance, we want first to observe a peak in European inflation. Inflation represents the greatest problem for the European economy. If inflation continues to surge, the purchasing power of households will deteriorate further and the ECB will ratchet up its hawkish rhetoric, which will cause considerable mayhem in the European economy.   A Reprieve For Europe? Only when the income suppressing impact of inflation recedes will European growth strengthen. Chart 1Paying More For The Same Paying More For The Same Paying More For The Same Higher prices continue to hurt European consumption. As witnessed in the US, European retail sales are rising in nominal terms (Chart 1). However, households are not consuming more; they are spending more to purchase the same amount of goods, which is illustrated by the stagnation in retail sales volumes over the past twelve months. Households are not increasing the size of their consumption baskets, because their incomes are not keeping up with inflation. Unlike in the US, Eurozone households never saw their real disposable income spike during the pandemic because European governments focused on preserving jobs rather than distributing large handouts to households. As a result, European real disposable income began to lag its pre-pandemic trend (Chart 2). As the economy recovered, disposable income did not converge back to trend. Now that food and energy prices have spiked, the gap between real disposable income and its trend is only widening. Wages are not coming to the rescue either. The European labor market has been incapable of generating the same kind of wage growth that the US labor market has enjoyed. Even the recent uptick in negotiated wages is not as strong as it seems. German workers benefited from a one-off payment that caused wages to spike by 6.7%, elevating the Euro Area average to 2.8% from 1.6%. However, without that adjustment, German underlying wage growth fell from 3.9% to 1.6% (Chart 3), which means that the underlying European wage only rose by 2%. Chart 2Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Chart 3Not As Strong As It Seems Not As Strong As It Seems Not As Strong As It Seems The distinction between one-off payments and underlying wages matters. As per Milton Friedman’s permanent income hypothesis, households are unlikely to shift their consumption pattern based on a temporary boost to income. They will save it, or in today’s case, use their one-off payment to cover their food and energy price increases. If today’s wage boost is not repeated, but inflation remains elevated, consumption will suffer. Europe’s tourism industry would be another major beneficiary from the peak in inflation. Prior to the pandemic, tourism contributed to 13%, 14% and 9% of the Italian, Spanish, and French economies, respectively. This sector was decimated during the pandemic after travel came to a halt. We are seeing positive signs emerge on this front. In the spring of 2021, nights spent at hotels were 80% below their spring 2019 levels for the Euro Area (Chart 4). As of March 2022, this variable is now between 15% and 30% below their March 2019 levels in Italy and France, respectively. Moreover, Google Mobility indices for the retail and recreation sectors have almost fully recovered (Chart 5). Thus, we can expect these trends to gather steam once inflation slows, because it will free up household disposable income. Europe’s periphery is particularly well placed to benefit from this eventual positive development. Chart 4Improving Tourism Sector Improving Tourism Sector Improving Tourism Sector Chart 5Mobility Pick-Up Mobility Pick-Up Mobility Pick-Up Positively, European inflation will peak soon. Commodity prices remain elevated, but commodity inflation has decelerated significantly. Hence, the commodity impulse is consistent with an imminent decline in Euro Area HICP (Chart 6). A simulation using BCA’s Commodity & Energy forecast for Brent, which also assumes that European natural gas prices will continue to hover around EUR100/MWh and that EUR/USD will hit 1.1 by year-end, confirms that energy inflation will swoon (Chart 7). Even if we assume a sudden surge in energy prices due to a Russian natural gas cutoff, energy inflation will recede in the second half of 2022 after spiking this summer. Chart 6Peak Inflation? Peak Inflation? Peak Inflation? Chart 7Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Chart 8Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Beyond the energy market, global forces also point toward a peak in European inflation in the coming months. The surge in US goods consumption over the past 24 months was felt globally and generated inflationary pressures in Europe as well. However, US durable goods consumption is declining (Chart 8). As a result, this important driver of European inflation will recede. Bottom Line: European consumption will not recover until inflation peaks. Without a deceleration in inflation, household disposable income will remain weak and consumers will remain careful. The good news is that European inflation is still on track to begin its descent this summer, which will boost the prospect for consumer spending and tourism. ECB Update: A Fall Pause? In a blog post last Monday, ECB president Christine Lagarde confirmed that the central bank will lift interest rates in July and will push the deposit rate to zero by September. Chart 9Too Much Priced In Too Much Priced In Too Much Priced In The economy is likely able to handle those two rate hikes. Our ECB monitor highlights the need to remove monetary accommodation in the Eurozone (Chart 9). Moreover, the German 2-/10-year yield curve has steepened this year, despite the hawkish shift in the ECB’s rhetoric, which confirms that monetary conditions are extremely accommodative. We expect the ECB to pause its rate hike campaign after exiting negative rates this fall to reassess economic conditions. Constraints on the ECB remain potent. If the central bank ignores these limiting factors, a policy mistake will ensue. Inflation is likely to decelerate by the end of the summer, which will undercut the hawks driving the consensus at the Governing Council today. Inflation is the factor pushing the ECB Monitor higher right now, not growth conditions (Chart 9, second panel). Thus, the case for lifting rates will weaken considerably when inflation slows. Growth is unlikely to have recovered enough by September to justify additional rate hikes after inflation slows. The expected improvement in consumption and household finances discussed earlier will be embryonic by the end of the summer and will not offer a clear case to lift rates further. Instead, the ECB will still have to juggle the tightening in financial conditions created by wider bond spreads in the European periphery and the impact of China’s slowdown on European exports. Meanwhile, capex is unlikely to strengthen meaningfully as long as global trade softens. As a result, we stay long the June 2023 Euribor futures. An extended pause after the September meeting will prevent the ECB from hiking rates as much as money markets expect over the coming twelve months (Chart 9, bottom panel). If the ECB goes ahead and continues to lift rates in the fall and early winter, the European economy will weaken considerably more and the previous rate hikes will have to be undone. Both scenarios are bullish for the June 2023 Euribor contract. Bottom Line: The ECB is likely to pause after pushing its deposit rate to zero in the third quarter in order to reassess economic conditions. Inflation is the main factor behind higher rates, and it will peak this summer. Meanwhile, the economy is still not strong enough to justify significantly higher interest rates. The market’s pricing in the ESTR curve is much too aggressive considering this context. Stay long June 2023 Euribor futures. Credit Update: Don’t Be A Hero Chart 10Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Credit markets are experiencing a second episode of spread widening this year. The first episode was triggered by the invasion of Ukraine by Russia. The current one reflects strong inflation, weaker growth prospects, and the ECB’s policy shift. Year-to-date, European investment grade and high-yield corporate bond option-adjusted spreads have widened by 74bps and 188bps, respectively (Chart 10, top panel). As we wrote last week, if the global economic situation were to stabilize, then European assets would be a buy at current levels. This is especially true for European credit. Beyond attractive valuations, corporate bond issuers’ balance sheets are in good shape and the default risk is low.   However, the same risks that prevent us from being buyers of the euro and European stocks today also hang over the credit market. Specifically, a further deterioration of the energy flows between Russia and the EU and/or a policy mistake, whereby the ECB delivers the seven rate hikes priced in the overnight index swap market, would cause spreads to widen meaningfully from their current elevated levels. Therefore, we recommend investors remain on the sidelines and wait for a safer entry point over the coming weeks. Once inflation has peaked and stagflation/recession fears recede, then credit spreads will have ample room to narrow, especially if the ECB decides to pause after lifting the deposit rate to 0% (Chart 10, second panel). In the meantime, expected policy rate differentials are still supportive of an overweight on European credit relative to US credit (Chart 10, bottom panel). Bottom Line: European spreads are most likely peaking. However, the same risks that hang over EUR/USD and European equities prevent us from buying this asset class just yet. Swiss Stocks Are Getting Expensive Chart 11Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings The defensive Swiss market has greatly outperformed its Euro Area counterpart this year. However, the recent bout of Swiss outperformance has been completely dissociated from the trend in Swiss EPS relative to those of the Euro Area (Chart 11). Now, Swiss equities are particularly expensive and sport multiples 45% greater than the P/E ratio of the Eurozone MSCI benchmark. This bifurcation between the relative performance of Swiss stocks and their relative earnings represents a trading opportunity. Specifically, Swiss shares look vulnerable against German ones, which have been seriously beaten down in recent years. Chart 12Priced For The Apocalypse Priced For The Apocalypse Priced For The Apocalypse Swiss stocks have been re-rated on the back of many forces. First, the valuations of Swiss stocks relative to German ones have risen in tandem with the Eurozone’s headline and core inflation (Chart 12, top and second panel). Swiss relative valuations have also benefited from the significant tailwind created by higher 2-year rates in the Eurozone (Chart 12, third panel) and from the weakness in the euro (Chart 12, fourth panel). Finally, Swiss relative valuations seem to have already priced in a significant deterioration in European manufacturing activity, which would have lifted their appeal as a defensive play (Chart 12, bottom panel). We recommend selling Swiss stocks against German ones. We anticipate European inflation to peak this summer. Our ECB view is consistent with a decline in Germany’s 2-year bond yields. We also expect the euro to bottom and, even though we have written about a deterioration in European manufacturing activity, the recent explosion of Swiss multiples relative to German ones looks overdone. This trade may be seen as our first attempt to dip our toe into cyclical assets, even if we generally favor capital preservation over risk taking at this juncture. Bottom Line: The outperformance of Swiss equities is overextended and is already pricing in a dire outcome for European economies. Selling Swiss shares relative to German stocks is an attractive way to add tentatively some risk to a European portfolio. France Update: Likely Legislative Majority For Macron Chart 13French Polls Suggest Macron Will Get His Legislative Majority Looking Beyond Europe’s Inflation Peak Looking Beyond Europe’s Inflation Peak President Emmanuel Macron’s political party, Renaissance (previously En Marche!), may surprise to the upside in this year’s legislative election. An aggregate of recent polls (Chart 13) suggests that the presidential coalition (which includes Renaissance and its allies) will obtain between 295 and 340 seats in the Assemblée Nationale, more than the 289 seats needed to achieve a majority. The odds of seeing an historically low voter turnout should also play in the French president’s favor. Chart 14Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Macron will not have to compromise to build a coalition in favor of his reform agenda, which bodes well for French productivity and trend growth. This election should not have an impact on French assets beyond that. We continue to recommend investors favor French small-caps, as they will benefit from an improvement in domestic consumer confidence and an eventual strengthening in the euro (Chart 14). Meanwhile, we still see more downside for French consumer stocks (Chart 14, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary First IG, Then HY First IG, Then HY First IG, Then HY Corporate bonds are following the 2018 roadmap. Investment grade underperformed Treasuries as interest rate expectations rose from low levels, then junk joined the selloff once rate expectations moved above estimates of neutral. Inflation is too high for the Fed to abandon its tightening cycle, as it did in 2018/19, but the Fed will move more slowly than what is priced in the curve for 2022. Underlying economic growth is stronger than it was in 2018 and corporate balance sheets are in better shape. That being the case, even a modest dovish surprise from the Fed will be sufficient for corporate bond returns to form a bottom. Municipal bonds are attractively priced versus both Treasuries and credit, and state & local government balance sheets are in excellent condition. Stay overweight.   Bottom Line: We maintain our cautious stance on corporate bonds for the time being, but are now on upgrade watch. Signs of peaking inflation and/or dovish signals from the Fed could cause us to increase exposure in the relatively near term. Stay tuned.  Feature The similarities between recent market action and what occurred in 2018 are striking. Back in 2018, the Fed was in the process of lifting the policy rate back toward estimates of neutral. The yield curve flattened as a result, and investment grade corporate bonds responded to the removal of policy accommodation by underperforming duration-matched Treasuries (Chart 1). Chart 1The 2018 Experience The 2018 Experience The 2018 Experience Despite the Fed’s actions, high-yield initially performed well in 2018. That is, until the market started to believe that the Fed would over-tighten. Recession fears increased in late 2018 as near-term rate expectations surpassed estimates of neutral and high-yield sold off sharply, giving back all of its gains from earlier in the year and then some. Now let’s turn to the present day (Chart 2). Once again, investment grade corporates underperformed Treasuries as near-term rate expectations moved higher and the yield curve flattened. For its part, high-yield performed well during the early stages of the interest rate adjustment but returns plunged once 12-month forward rate expectations moved above survey estimates of neutral. Chart 2First IG, Then HY First IG, Then HY First IG, Then HY What’s Different This Time? While we think the 2018 roadmap is a good one, it’s important to consider the differences between 2018 and today before drawing any firm conclusions about future credit market performance. The first obvious difference is that the Fed had already been lifting rates for some time in 2018. In fact, the fed funds rate was above 2%. Today, the Fed is still in the early stages of its tightening cycle and the fed funds rate is only 0.83%. We think this difference is less significant than it initially appears because the level of the fed funds rate itself is less important than the perceived restrictiveness of monetary policy. Today, the market is priced for the fed funds rate to hit 3.18% in 12 months, higher than at any point in 2018 (Chart 3). We also see that the Treasury slope beyond the 2-year maturity point is about as flat today as it was in 2018 (Chart 3, bottom panel). This strongly suggests that the market perceives monetary policy as about as restrictive today as it was in late 2018. The second difference we identify is that inflation is much higher today than it was in 2018 (Chart 4). This is potentially bad news for future credit market performance. High inflation gives the Fed a strong incentive to keep lifting rates even if risky assets sell off. In 2018, the Fed reversed course on its tightening cycle once broad financial conditions tightened into restrictive territory. That’s an easy decision to make when inflation is close to 2%. It’s much more difficult to do with inflation where it is now. Chart 3Monetary Conditions Are Similar Monetary Conditions Are Similar Monetary Conditions Are Similar Chart 4Inflation Is Much Higher … Inflation Is Much Higher ... Inflation Is Much Higher ... High inflation makes it unlikely that the Fed will pull a 180 on its tightening cycle. But on the flipside, today’s strong underlying economic growth means that a complete reversal on rate hikes is probably not necessary to avoid a recession. Just look at the labor market. Labor market utilization, as measured by both the unemployment rate and the prime-age employment-to-population ratio, is in a similar place today as it was in 2018 (Chart 5). However, despite a tight labor market, job growth is running at a much stronger pace this year. Nonfarm payroll gains have averaged 523 thousand during the past three months. In 2018, in a similarly tight labor market, monthly job growth averaged just 191 thousand. Now turn to housing, arguably the most important channel through which interest rates impact the economy. In a prior report we identified that the 12-month moving average of housing starts dipping below the 24-month moving average is a good indicator for the end of a Fed rate hike cycle.1 In 2018, our housing starts indicator was barely positive. Today, it is extremely elevated (Chart 5, bottom panel). Chart 5… But Growth Is Much Stronger ... But Growth Is Much Stronger ... But Growth Is Much Stronger The key point is that with employment growth and housing starts trending at much better levels than in 2018, we can conclude that the Fed has a fair amount of scope to tighten policy before threatening to push the economy into recession. The upshot for corporate bond markets is that the threshold for Fed capitulation is also different. While a full backtracking away from rate hikes was necessary to avoid a recession and spur corporate bond outperformance in 2018, both the economy and financial markets likely require less of a Fed reversal today. The final difference we identify between 2018 and today relates to the health of corporate balance sheets (Chart 6). Compared to 2018, nonfinancial corporations are carrying much less debt as a percentage of net worth, have significantly higher interest coverage and are benefiting from net ratings upgrades. Much like with the labor market and housing indicators, there’s every reason to believe that corporations are better equipped to handle higher interest rates today than they were in 2018. Chart 6Balance Sheets Are Healthier Balance Sheets Are Healthier Balance Sheets Are Healthier The Way Forward If we look back at Chart 1, we see that the 2018 roadmap is for the Fed to abandon its tightening cycle, leading to a sharp drop in near-term rate expectations and a V-shaped bottom in excess corporate bond returns. We won’t get such a swift Fed reversal this year, but there are strong odds that the Fed will lift rates by less than what is currently discounted in the market between now and the end of 2022. As we noted in last week’s Webcast, we expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before shifting to 25 bps per meeting increments in September once it’s clear that inflation is trending down (Chart 7).2  We also see potential for relief at the long-end of the yield curve, where 5-year/5-year forward Treasury yields have room to fall back toward survey estimates of the long-run neutral rate (Chart 8). Chart 7Rate Expectations Rate Expectations Rate Expectations Chart 8Yields Above Fair Value Yields Above Fair Value Yields Above Fair Value It’s also worth noting that corporate bond valuations have improved markedly during the past few weeks. The 12-month breakeven spread for investment grade corporates is back above its historical median, and the junk index is priced for a 6.3% default rate during the next 12 months (Chart 9). Investment grade and high-yield index spreads are also now well above their respective 2017-19 averages, as is the spread differential between high-yield and investment grade (Chart 10). Chart 9Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation Chart 10Favor HY Over IG Favor HY Over IG Favor HY Over IG The bottom line is that we are slowly turning more positive on corporate bonds. Falling inflation will cause the Fed to tighten by less than what is expected this year, and it will soon become apparent that – as was the case in 2018 – the US economy is not close to tipping into recession. Spreads also present an increasingly attractive opportunity. That said, with the Fed still poised to deliver 100 bps of tightening within the next two months, we are not yet ready to abandon our relatively cautious corporate bond allocation. We maintain our underweight (2 out of 5) allocation to investment grade corporate bonds and our neutral (3 out of 5) allocation to high-yield, but we are now firmly on upgrade watch. Signs of peaking inflation and/or signals that the Fed will pivot to a hiking pace of 25 bps per meeting could cause us to increase our recommended corporate bond exposure in the relatively near term. Stay tuned. Seek Refuge In Municipal Bonds While we wait for clearer signs of a bottom in corporate credit, investors can more confidently deploy capital in the municipal bond market. Municipal / Treasury yield ratios have jumped in recent weeks, and they are now back above post-2010 averages across the entire yield curve (Chart 11). Long-maturity municipal bonds are even trading at a before-tax premium relative to US Treasuries (Chart 11, top 2 panels). Municipal bonds are also trading at above-average yields relative to credit rating and duration-matched corporate bonds (Chart 12). This is despite the recent back-up we’ve witnessed in corporate bond spreads. Chart 11Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 12Munis Cheap Versus Credit Munis Cheap Versus Credit Munis Cheap Versus Credit Not only are munis attractively priced versus both Treasuries and corporates, but state & local government balance sheet indicators show that municipal credit quality is sky high (Chart 13). Tax revenues have accelerated since the pandemic, but state & local governments have remained cautious about spending their windfalls. Despite being flush with cash, state & local governments have re-hired only a small fraction of the employees that were let go during the pandemic (Chart 13, panel 2). The result of this lack of spending is that state & local government net savings are the highest they’ve been in years (Chart 13, panel 3). Chart 13State & Local Government Health State & Local Government Health State & Local Government Health Bottom Line: Municipal bonds are attractively valued versus both Treasuries and investment grade corporates, and state & local government balance sheets are in superb condition. Investors should overweight municipal bonds in US fixed income portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 2 https://www.bcaresearch.com/webcasts/detail/537 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Image Chart 4Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Wage Pressures May Be Starting To Ease Image Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included ... Small Business Owners Included ... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Image Chart 9When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock Individual Investors Still Hold A Lot Of Stock   Image Chart 20B... But They Like Bonds Even Less ... But They Like Bonds Even Less ... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Image A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) 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 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A Special Trade Recommendations Current MacroQuant Model Scores Goldilocks: A Skeptical Q&A Goldilocks: A Skeptical Q&A

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 17 at 9:00 AM EDT, 14:00 PM BST, 15:00 PM CEST and May 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

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