Corporate Bonds

Executive Summary The Fed is in a tough spot. On the one hand, rising long-dated inflation expectations will incentivize it to tighten more quickly. On the other hand, the flat yield curve and poor risky asset performance point to a heightened risk of recession if it tightens too aggressively. The Fed will try to split the difference by lifting rates at a steady pace of 25 bps per meeting, starting this week. Though upside risks have increased, it remains likely that core inflation will peak within the next couple of months. This will allow the Fed to continue tightening at a steady pace, one that is already well discounted in the market. Monthly Core Inflation By Major Component A Soft Landing Is Still Possible A Soft Landing Is Still Possible Bottom Line: Investors should keep portfolio duration close to benchmark and favor yield curve steepeners. Corporate bond spreads will continue to widen in the near-term, but a buying opportunity will soon emerge. A Tough Spot For The Fed A lot has happened since we shifted our portfolio duration recommendation from “below benchmark” to “at benchmark” on February 15. The Russian invasion of Ukraine sent bond yields sharply lower the following week but yields have since recovered and are now close to where they were when we upgraded our duration view (Chart 1). That said, the round-trip in nominal yields masks some significant moves in the real and inflation components. The 10-year TIPS breakeven inflation rate is currently 2.98%, up from 2.45% on February 15, and the 5-year/5-year forward TIPS breakeven inflation rate has moved up to 2.38% from 2.05% (Chart 2). In the past two weeks we’ve also seen a further flattening of the yield curve (Chart 2, panel 3) and widening of credit spreads (Chart 2, bottom panel). Chart 2A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock Chart 1Round-Trip Round-Trip Round-Trip Taken together, recent market moves are consistent with a stagflationary shock. Long-dated inflation expectations are higher, but the yield curve is flatter and risk assets have sold off. This sort of environment is a complicated one for Fed policy. On the one hand, rising long-dated inflation expectations give the Fed a greater incentive to tighten quickly. On the other hand, rapidly tightening financial conditions increase the risk that the Fed may move too aggressively and push the economy into recession. So what’s the Fed to do? For now, it will try to split the difference. In practice, this means that the Fed will start tightening policy this week and proceed with a steady rate hike pace of 25 basis points per meeting. Once this process starts, we see two possible scenarios. The first possible scenario is that the Fed achieves its “soft landing”. A steady hike pace of 25 bps per meeting proves to be slow enough that financial conditions tighten only gradually, the yield curve retains its positive slope and inflation peaks within the next couple of months, halting the upward trend in long-dated inflation expectations. This benign scenario is still more likely than many people appreciate. For starters, the bond market is already priced for close to seven 25 basis point rate hikes this year, the equivalent of one 25 bps hike per meeting (Chart 3). This means a 50 bps hike at some point this year is required for the Fed to deliver a hawkish surprise to near-term expectations. In our view, a 50 bps hike is unlikely unless long-dated inflation expectations continue to move higher and become obviously “un-anchored”. If inflation peaks within the next couple of months, in line with our base case outlook, then so will long-dated expectations. Chart 3Rate Expectations Rate Expectations Rate Expectations The second possible scenario is that we see no near-term relief on the inflation front. Global supply chains remain disrupted by the war in Ukraine and surging COVID cases in China, and commodity prices continue their upward march. This would initially lead to even higher long-dated inflation expectations and an even faster pace of expected Fed tightening. It could even lead to a 50 bps Fed rate hike at some point, though we think it’s more likely that it would lead to an inverted yield curve and a severe tightening of financial conditions (i.e. sell off in equities and credit markets) before the Fed even gets the chance to deliver a 50 bps hike. Investment Implications The “soft landing” scenario remains our base case view. The Fed will start tightening in line with current market expectations and core inflation will peak within the next couple of months, keeping long-dated inflation expectations in check. Related Report  US Investment StrategyQ&A On Ukraine, Financial Markets And The Economy The correct investment strategy for this outcome is to keep portfolio duration close to benchmark and to favor a 2/10 yield curve steepener (buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note). Not only is the front-end of the bond market fully priced for a steady hike pace of 25 bps per meeting, but the 5-year/5-year forward Treasury yield is close to median survey estimates of the long-run neutral fed funds rate. This suggests that the upside in long-dated bond yields is limited (Chart 4). As for the yield curve, assuming that the Fed’s well-discounted steady pace of tightening is unlikely to invert the curve, then it makes sense to grab the extremely attractive yield pick-up available in the 2-year note versus a duration-matched cash/10 barbell (Chart 5). Chart 4Close to Fair Value Close to Fair Value Close to Fair Value Chart 5A Huge Yield Pick-Up In Steepeners A Huge Yield Pick-Up In Steepeners A Huge Yield Pick-Up In Steepeners The investment implications of our second “un-anchored inflation expectations scenario” are more difficult to game out. However, we think the most likely outcome is that bond yields would rise initially, driven by inflation expectations, and then plunge once the yield curve inverts and it becomes clear that the Fed will be forced to tighten the economy into recession. This is not our base case scenario, but investors with a 6-12 month investment horizon who wish to position for this outcome should probably extend portfolio duration rather than shorten it. The 2022 Inflation Outlook A key pillar of the “soft landing” scenario described above is that core inflation peaks within the next couple of months and starts to head lower in H2 2022. Today, we’ll assess the likelihood of that occurring by looking at the three main components of core CPI inflation: goods, shelter, and services (excluding shelter). The first fact to consider is that month-over-month core CPI has printed between 0.5% and 0.6% in each of the past five months, almost matching the extreme inflation readings seen between April and June 2021 (Chart 6). If month-over-month core inflation continues to print at 0.5%, then year-over-year core CPI will drop between March and June before rising again to reach 6.3% by the end of the year (Chart 7). Conversely, if month-over-month core inflation declines to 0.3%, then year-over-year core inflation will fall steadily to 4.2% by the end of 2022. Chart 6Monthly Core Inflation By Major Component A Soft Landing Is Still Possible A Soft Landing Is Still Possible Chart 7Annual Inflation Annual Inflation Annual Inflation These two outcomes likely have different implications for policy and markets. The world where core inflation remains sticky above 6% probably coincides with expectations of rapid Fed tightening, a near-term inversion of the yield curve and rising expectations of recession. Conversely, the world where core inflation falls to 4.2% by the end of 2022 and appears to be on a downward trend probably coincides with well-contained inflation expectations and a steady pace of Fed tightening. We therefore want to know which of these outcomes is more likely. To do that we consider the outlooks for core inflation’s three main components. 1. Core Goods Chart 8Goods Inflation Goods Inflation Goods Inflation Goods have been the main driver of elevated inflation during the past year, especially the new and used car segments (Chart 8). Prior to the pandemic, core goods inflation tended to fluctuate around 0%. Currently, the year-over-year rate is up around 12%. We view a significant decline in core goods inflation as highly likely this year. First off, used car prices – as measured by the Manheim Used Vehicle Index – have already moderated (Chart 8, panel 2), while other measures of supply bottleneck pressures like the ISM manufacturing supplier deliveries and prices paid indexes are rolling over, albeit from high levels (Chart 8, panel 3). Reduced demand should also ease some of the upward pressure on goods prices this year. Consumer spending on goods dramatically overshot its pre-COVID trend during the past two years (Chart 8, bottom panel) as spending on services was often not possible. With US COVID restrictions on the verge of being completely lifted, some spending is likely to shift away from goods and towards services in 2022. The recent news of a surging omicron COVID wave in China and renewed lockdown measures already in place in Shenzhen province may delay the re-normalization of supply chains. As of yet, we think it’s premature for this to alter our view. The omicron experience of other countries suggests that the wave will be quick and that restrictions will not be as severe as in past COVID waves.  2. Shelter Shelter is the largest component of core CPI and it is also the most tightly correlated with the economic cycle. That is, it tends to accelerate when economic growth is trending up and the unemployment rate is falling, and vice-versa. Shelter faces two-way risk in 2022. The upside risk comes from private measures of asking rents and home prices that have already surged. The Zillow Rent Index is up 15% during the past 12 months and the Zillow Home Price Index is up 20% (Chart 9A). Recent research has shown that these private measures tend to feed into core CPI with a lag of about one year.1 The downside risk to shelter inflation this year comes from the economic cycle itself. Chart 9B shows that there is a tight correlation between shelter inflation and the unemployment rate, and between shelter inflation and aggregate weekly payrolls (employment x hours x wages). The unemployment rate’s rapid 2021 decline will not persist this year. The labor market is nearing full employment and last year’s fiscal impulse has faded. Chart 9BShelter Inflation II Shelter Inflation II Shelter Inflation II Chart 9AShelter Inflation I Shelter Inflation I Shelter Inflation I Netting it all out, we think shelter inflation will continue to trend higher for the next few months but will eventually level-off near the end of this year as economic growth slows. 3. Core Services (excluding Shelter) Services inflation printed an extremely strong 0.55% month-over-month in February, though a large portion of that increase was driven by pandemic-related services like airfares and admission to events, increases that will moderate now that the omicron wave has passed. More fundamentally, wage growth is the key driver of services inflation, and it has been extremely strong. The Atlanta Fed’s Wage Growth Tracker is up to 4.3% year-over-year, its highest since 2002, and it is showing signs of broadening out to wage earners of all levels (Chart 10). Though we see wage growth remaining strong, its acceleration is also likely to moderate in the coming months. The Census Bureau’s most recent Household Pulse Survey showed that almost 8 million people were absent from work in February because they were either sick with COVID themselves or caring for someone with COVID symptoms (Chart 11). Near-term wage demands will moderate during the next few months as the pandemic ebbs and these people return to work. Chart 10Wage Growth Is Strong Wage Growth Is Strong Wage Growth Is Strong Chart 11Covid Still Weighing On Labor Supply Covid Still Weighing On Labor Supply Covid Still Weighing On Labor Supply We also must grapple with the possible deflationary fall-out from the recent energy and gasoline price shock. Real household incomes are declining (Chart 12A), and while consumers have ample room to either tap their savings or increase debt to support spending (Chart 12B, top panel), the recent plunge in consumer sentiment suggests that they may behave more cautiously (Chart 12B, bottom panel). Chart 12AReal Incomes Are Falling Real Incomes Are Falling Real Incomes Are Falling Chart 12BConsumer Confidence Is Low Consumer Confidence Is Low Consumer Confidence Is Low Putting It Together We could see core goods inflation falling all the way back to a monthly rate of 0% this year. This would be consistent with its pre-pandemic level, but also wouldn’t incorporate any outright price declines – which are also possible. If we additionally assume some further acceleration in Owner’s Equivalent Rent and Rent of Primary Residence, to 0.6% per month, and a slight pullback in services inflation to a still-strong 0.3% per month, then overall core CPI inflation would hit a monthly rate of 0.34%, consistent with annual core CPI inflation of 4.2%. We think this is a reasonable forecast though we see risks to the upside driven by another bout of supply chain pressures in manufactured goods. In general, we expect year-over-year core CPI inflation to reach a range of 4% to 5% by the end of this year. That would be consistent with the “soft landing” scenario described earlier in this report. Corporate Bonds: Waiting For A Buying Opportunity To Emerge Chart 13Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation Finally, a quick update on our corporate bond allocation. Corporate bonds have sold off sharply versus Treasuries since February 15. The investment grade corporate bond index has underperformed a duration-equivalent position in Treasury securities by 217 bps while High-Yield has underperformed by a less dramatic 120 bps. With economic risks high and the Fed on the cusp of a tightening cycle, we think further spread widening is likely in the near-term. However, if the “soft landing” scenario described earlier in this report pans out, then we will soon see a buying opportunity in corporate bonds. The 12-month quality-adjusted breakeven spread for the investment grade corporate index has risen close to its historical median, from near all-time expensive levels only a few months ago (Chart 13). While a flat yield curve poses a risk to corporate bond returns, wide spreads may soon become too attractive to ignore. Table 1A shows average historical 12-month investment grade corporate bond excess returns given different starting points for the 3-year/10-year Treasury slope and the 12-month corporate breakeven spread. Table 1B shows 90% confidence intervals for those average returns and Table 1C shows the percentage of instances in which excess returns were above 0%. Table 1AAverage 12-Month Future Investment Grade Corporate ##br##Bond Excess Returns* (BPs) A Soft Landing Is Still Possible A Soft Landing Is Still Possible Table 1B90 Percent Confidence Interval Of 12-Month Investment Grade Corporate Bond Excess Returns* (BPs) A Soft Landing Is Still Possible A Soft Landing Is Still Possible Table 1CPercentage Of Episodes With Positive 12-Month Investment Grade Corporate Bond Excess Returns* A Soft Landing Is Still Possible A Soft Landing Is Still Possible At present, the 3-year/10-year Treasury slope is +9 bps and the 12-month breakeven spread is 18 bps. Historically, this sort of environment is consistent with positive excess corporate bond returns 59% of the time, but with a negative average return overall. That said, if the yield curve retains its positive slope, then a further 18 bps of corporate index spread widening would push the 12-month breakeven spread above the 20 bps threshold. The historical record suggests that this would be an unambiguous buy signal. Bottom Line: We are sticking with our recommended 6-12 month corporate bond allocations for now. We are neutral (3 out of 5) on investment grade and overweight (4 out of 5) on high-yield. A yield curve inversion and heightened risk of recession would cause us to turn more cautious, but we think it’s more likely that widening spreads present us with an opportunity to upgrade our corporate bond allocations within the next few months. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.frbsf.org/economic-research/publications/economic-letter/2022/february/will-rising-rents-push-up-future-inflation/ Treasury Index Returns Spread Product Returns Recommended Portfolio Specification A Soft Landing Is Still Possible A Soft Landing Is Still Possible Other Recommendations A Soft Landing Is Still Possible A Soft Landing Is Still Possible

Highlights Chart 1A Tough Balancing Act For The Fed A Tough Balancing Act For The Fed A Tough Balancing Act For The Fed In last week’s Congressional testimony, Fed Chair Jay Powell talked about his goal of achieving a “soft landing”. That is, the Fed will tighten enough to slow inflation but not so much that the economy tips into recession. This balancing act was always going to be difficult, and recent world events have only complicated it. On the one hand, the US labor market has essentially returned to full employment. The prime-age employment-to-population ratio is just 1% below its pre-COVID level, a gap that will soon be filled by the 1.2 million people being kept out of the labor force by the pandemic (Chart 1). On the other hand, risk-off market moves driven by the war in Ukraine have caused the yield curve to flatten (Chart 1, bottom panel). The Fed’s task is to respond to the strong US economy by lifting rates, but to also avoid inverting the yield curve. To split the difference, the Fed will proceed with a 25 bps rate hike at each FOMC meeting, but will slow down if the curve inverts. Our recommended strategy is to keep portfolio duration close to benchmark for the time being given the uncertainty in Ukraine. However, the Treasury curve is now priced for too shallow a path for rate hikes. We are actively looking for a good time to re-initiate duration shorts. Feature   Table 1Recommended Portfolio Specification Sticking The Landing Sticking The Landing Table 2Fixed Income Sector Performance Sticking The Landing Sticking The Landing Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 124 basis points in February, dragging year-to-date excess returns down to -238 bps. The index option-adjusted spread widened 16 bps on the month and it currently sits at 130 bps. Our quality-adjusted 12-month breakeven spread has moved up to its 36th percentile since 1995 (Chart 2). The corporate bond sell-off that began late last year on heightened expectations of Fed tightening has accelerated in recent weeks, this time driven by the war in Ukraine. The result of the turmoil is that a significant amount of value has returned to the corporate bond market. In fact, spreads have not been this wide since early 2021. Continued uncertainty about how the Ukrainian situation will evolve causes us to recommend a neutral stance on investment grade corporate bonds in the near term. However, enough value has been created that a buying opportunity could soon emerge. Corporate balance sheets remain healthy. In fact, the ratio of total debt to net worth on nonfinancial corporate balance sheets is at its lowest level since 2010 (bottom panel). Further, the most likely scenario is that the economic contagion from Russia/Ukraine to the United States will be limited. While Fed tightening is set to begin this month, spreads are now wide enough that a flat but positively sloped yield curve is not sufficient to justify an underweight stance on corporate bonds. Investors should stay neutral for now but look for an opportunity to turn more bullish. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Sticking The Landing Sticking The Landing Table 3BCorporate Sector Risk Vs. Reward* Sticking The Landing Sticking The Landing High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 56 basis points in February, dragging year-to-date excess returns down to -213 bps. The index option-adjusted spread widened 17 bps on the month and it currently sits at 376 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 – also moved up to 4.6% (Chart 3). The odds are good that defaults will come in below 4.6% during the next 12 months, and as such, we expect high-yield bonds to outperform a duration-matched position in Treasuries. This warrants a continued overweight allocation to High-Yield on a cyclical (6-12 month) horizon, though we acknowledge that further spread widening is likely until the situation in Ukraine reaches a place of greater stability. High-Yield valuations continue to be more favorable than for investment grade corporates (panel 3). We therefore maintain a preference for high-yield corporate bonds over investment grade.       MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 48 basis points in February, dragging year-to-date excess returns down to -60 bps. The zero-volatility spread for conventional 30-year agency MBS widened 12 bps on the month, driven by an 11 bps widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) increased by 1 bp on the month (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.1 This valuation picture is starting to change. The option cost is now up to 44 bps, its highest level since 2016 and refi activity is slowing as the Fed moves toward rate hikes. At 30 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. We closed our recommendation to favor high coupon over low coupon securities on February 15th, concurrent with our decision to increase portfolio duration. We will likely re-establish this position when we move portfolio duration back to below benchmark. 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 399 basis points in February, dragging year-to-date excess returns down to -483 bps. EM Sovereigns underperformed the Treasury benchmark by 519 bps on the month, dragging year-to-date excess returns down to -646 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 323 bps on the month, dragging year-to-date excess returns down to -379 bps. Russian sovereign bonds were recently downgraded to below investment grade, but before they were removed from the index they contributed -367 bps to Sovereign excess returns in February. In other words, if Russian securities are excluded, the EM Sovereign index only lagged Treasuries by 152 bps in February and actually outperformed a duration-matched position in US corporate bonds. As a result, the EM Sovereign index now offers less yield than a credit rating and duration-matched position in US corporate bonds (Chart 5). This recent shift in valuation leads us to reduce our recommended exposure to EM Sovereigns from overweight to underweight. Russian securities also negatively influenced EM Corporate & Quasi-Sovereign returns in February, but that index still offers a significant yield premium over US corporates whether Russian bonds are included or not (bottom panel). The turmoil overseas causes us to reduce exposure to this sector as well, but we will retain a neutral allocation instead of underweight because of still-attractive valuations. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 5 basis points in February, dragging year-to-date excess returns down to -126 bps (before adjusting for the tax advantage). While the war in Ukraine introduces 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. That said, relative muni valuations have tightened significantly during the past few months and the recent back-up in corporate spreads will eventually give us an opportunity to increase exposure to that sector. With that in mind, this week we downgrade our municipal bond allocation from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 5% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 11% versus corporates (panel 2). Both figures are down considerably from their 2020 peaks. For their part, high-yield muni spreads have also not kept pace with the recent widening in high-yield corporate spreads (bottom panel). Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened dramatically In February, driven by a re-pricing of Fed expectations in the first half of the month and then later by flight-to-quality flows spurred by the war in Ukraine. The 2/10 and 5/30 Treasury slopes flattened by 22 bps and 3 bps in February. They currently sit at 24 bps and 51 bps, respectively (Chart 7). As noted on the first page of this report, during the next few months the Fed will be forced to strike a balance between tightening policy fast enough to prevent a de-stabilizing increase in inflation expectations and slow enough to prevent an inversion of the yield curve. The latter would likely signal an unacceptable increase in recession risk. In the near-term, we view the risks as clearly tilted toward further curve flattening as the Fed initiates a rate hike cycle while geopolitical uncertainties keep a lid on long-dated yields. However, this dynamic will eventually give way when political uncertainties abate and/or the Fed is forced to move more slowly in response to an inverted (or almost inverted) curve. With that in mind, a position in curve steepeners continues to make sense on a 6-12 month investment horizon. We also maintain our recommendation to favor the 20-year bond over a duration-matched barbell consisting of the 10-year note and 30-year bond. This position offers an enticing 26 bps of duration-neutral carry. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 150 basis points in February, bringing year-to-date excess returns up to +127 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps. Perhaps the most interesting recent market move is that TIPS breakeven inflation rates rose during the past month, even as flight-to-safety flows surged into the US bond market. That is, while nominal Treasury yields declined, TIPS yields fell even more, and the cost of inflation compensation embedded in US bond prices increased. At present, the 10-year TIPS breakeven inflation rate is 2.70%, above the Fed’s 2.3% to 2.5% target range (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate is 2.16%, still below the Fed’s target range but significantly higher than where it was in January. The bond market has responded to the war in Ukraine and resultant surge in commodity prices by bidding up the cost of inflation compensation. While we agree that higher commodity prices increase the risk that inflation will remain elevated in the second half of the year, we still think the most likely outcome is that core inflation starts to moderate in the coming months as supply chain pressures ease and the pandemic exerts less of an impact on daily life. Upcoming Fed rate hikes will also apply downward pressure to long-maturity TIPS breakeven inflation rates. As a result, we maintain our recommended neutral allocation to TIPS versus nominal Treasuries at the long-end of the curve and re-iterate our recommendation to underweight TIPS versus nominal Treasuries at the front-end of the curve.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 25 basis points in February, dragging year-to-date excess returns down to -5 bps. Aaa-rated ABS underperformed by 25 bps on the month, dragging year-to-date excess returns down to -6 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -1 bp. 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: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 95 basis points in February, dragging year-to-date excess returns down to -98 bps. Aaa Non-Agency CMBS underperformed Treasuries by 90 bps on the month, dragging year-to-date excess returns down to -92 bps. Non-Aaa Non-Agency CMBS underperformed by 108 bps on the month, dragging year-to-date excess returns down to -105 bps (Chart 10). Though CMBS spreads remain wide compared to other similarly risky spread products, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 24 basis points in February, dragging year-to-date excess returns down to -21 bps. The average index option-adjusted spread widened 6 bps on the month. It currently sits at 46 bps (bottom panel). The average Agency CMBS spread remains below its pre-COVID level, but it continues 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 172 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 Appendix A: The Golden Rule Of Bond Investing 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. Sticking The Landing Sticking The Landing 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 February 28, 2022) Sticking The Landing Sticking The Landing 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 February 28, 2022) Sticking The Landing Sticking The Landing 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 -29 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 29 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) Sticking The Landing Sticking The Landing 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 February 28, 2022) Sticking The Landing Sticking The Landing Recommended Portfolio Specification Sticking The Landing Sticking The Landing Other Recommendations Sticking The Landing Sticking The Landing Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Treasury Index Returns Spread Product Returns

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

Executive Summary The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Given that a sustainable business cycle acceleration in China is unlikely in the short term, onshore government bond yields will likely drop further. In the long run, odds are that Chinese government bond yields will drop below US Treasury yields. For domestic asset allocators, we continue to recommend overweighting government bonds over stocks for now. The excess return of corporate bonds is driven by the corporate profit cycle. On a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. Bottom Line: Given our view that a meaningful growth recovery in China will only be a theme for the second half of this year, onshore asset allocators should continue favoring corporate credit over stocks and government bonds over corporate bonds. The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Feature In this report we (1) elaborate on our outlook for Chinese government and corporate bonds and (2) offer a framework for understanding how asset allocation for fixed-income (government and corporate bonds) and multi-asset portfolios (comprised of fixed-income plus equities) should be implemented. Domestic Government Bonds Chart 1Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend The risk-reward profile of Chinese domestic government bonds remains attractive. Chinese government bond yields have been declining,  bucking the global trend of surging government bond yields (Chart 1, top panel). Odds are that Chinese bond yields will drop further, both cyclically and structurally: In contrast with the Americas and Europe, China’s consumer price inflation has remained subdued. Its core, trimmed mean and headline inflation rates have remained low (Chart 2). The ongoing growth slump will cap core inflation in China at around 1%, allowing monetary authorities to lower interest rates further. Real bond yields in China remain well above those in the majority of DM (Chart 1, bottom panel). Hence, risk-free bonds in China offer value. As to the Chinese stimulus and business cycle, the recent pickup in Chinese credit numbers has been entirely due to local government bond issuance. After excluding local government bonds, credit growth and its impulse have not improved (Chart 3). While infrastructure spending will pick up in the coming months (given large special bond issuance), sentiment among consumers and private companies remains downbeat and local government budgets are severely impaired by the collapse in revenues from land sales. Hence, it will take some time before a boost in infrastructure activity lifts broader business and consumer sentiment such that a sustainable economic recovery can take hold. Chart 2Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chart 3Recent Credit Improvement Is Entirely Due to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance The special bond quota for Q1 stands at RMB 1.46 trillion and is equivalent to 28% of local government aggregate quarterly revenue. Even though the special bond issuance in Q1 is massive, it will be largely offset by the drop in local governments’ land sales revenue. The latter is shrinking and makes up more than 40% of local government aggregate revenues. In brief, strong headwinds from the property market in the form of shrinking land sales might counteract the increase from front-loaded special bond issuance in Q1 2022. As to real estate construction, funding for property developers is down dramatically from a year ago (Chart 4). In the absence of financing, real estate developers will shrink construction volumes in the months ahead. Chart 5Debt Service Burden For Chinese Enterprises And Households Is High Debt Service Burden For Chinese Enterprises And Household Is High Debt Service Burden For Chinese Enterprises And Household Is High Chart 4Property Completions Will Roll Over Property Completions Will Roll Over Property Completions Will Roll Over   Structurally, high enterprise and household debt levels in China amid slumping incomes mean that borrowing costs should drop to facilitate debt servicing. BIS estimates that debt service costs for the private sector (enterprises and households) in China are 21% of disposable income, much higher than in many other economies (Chart 5). Finally, China’s large and persistent current account surpluses mean that the nation is a major international creditor rather than a debtor. Thus, China does not need to offer high yields to attract foreign capital. Structurally speaking, foreign fixed-income inflows into Chinese domestic bonds will likely continue. Chart 6Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Bottom Line: Bond yields will likely drop further as a sustainable business cycle acceleration in China is unlikely in the short term. Chart 6 illustrates that the total social financing impulse leads bond yields by nine months and a cyclical bottom in yields will probably occur a few months from now. In the long run, Chinese government bonds yields will likely drop below US Treasury yields. Onshore Corporate Bonds The proper measure of corporate bond performance is excess return over similar government bonds (herein excess return). The basis for using excess return instead of total return for corporate bonds is because investors can attain government bond return by purchasing them outright. Essentially, investors prefer corporate bonds over government bonds because of credit spreads. Hence, a corporate bond performance assessment – whether in absolute terms or relative to other asset classes – should be based on excess return. In China, the excess return on onshore corporate bonds1 usually moves in tandem with the business cycle and government bond yields. In particular: The excess return of corporate bonds is positive during periods of growth acceleration and negative during slowdowns (Chart 7, top panel). The middle panel of Chart 7 illustrates that the excess return of corporate bonds correlates with analysts’ net EPS revisions for onshore listed companies. This confirms the above point that corporate bonds correlate with the profit/business cycle. Significantly, even though industrial profit growth is not yet negative (Chart 8, top panel), earnings in commodity-user industries have crashed (Chart 8, bottom panel).  This explains the negative excess return for onshore corporate bonds in the past 12 months. Chart 7The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Chart 8Corporate Profit Cycle: Mind The Divergence Corporate Profit Cycle: Mind The Divergency Corporate Profit Cycle: Mind The Divergency Furthermore, the excess return of corporate bonds declines and rises with interest rate expectations (Chart 7, bottom panel). As the outlook for corporate profits remains sour, fixed-income investors should continue to favor government bonds over corporate bonds. Now, how do corporate bonds perform versus stocks? What drives their relative performance? To compare stock performance to corporate bond excess return, one should adjust for volatility. In other words, share prices are much more volatile than the excess return on corporate bonds. Hence, during risk-on periods equities always outperform corporate bonds and vice versa. Chart 9The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical Chart 9 demonstrates that even on a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. In short, the performance of stocks over corporate bonds is very pro-cyclical. Bottom Line: The excess return of corporate bonds is driven by corporate revenue and profits rather than by interest rate expectations. Getting China’s business cycle right is critical to the allocation between government and corporate bonds in fixed-income portfolios and to the allocation between corporate bonds and equities in multi-asset portfolios. Given our view that a meaningful growth recovery in China will only be a theme in the second half of this year, onshore asset allocators should continue favoring corporate bonds over stocks and government bonds over corporate credit. Offshore Corporate Bonds What drives the excess return of Chinese USD corporate bonds in absolute terms as well as versus Chinese non-TMT investable stocks2 and onshore corporate bonds? Given that the offshore corporate bond universe is dominated by property developers, their excess return correlates with perceived risks to the mainland property market in general and the financial health of property developers in particular (Chart 10, top panel). Property developers are very overleveraged, their sales are shrinking and their financing has dried up. Yet, authorities are compelling them to complete construction of their pre-sold housing. Property developers will therefore continue to experience financial distress. Odds are that bond prices of corporate developers – both investment grade and high yield - will continue falling (Chart 10, middle and bottom panels). Chart 11Investable Stocks Vs. Offshore Corporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Chart 10A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds On a volatility-adjusted basis, non-TMT investable stocks outpace the excess return of offshore corporate bonds during periods of growth improvement and underperform during growth slowdowns (Chart 11, top panel). The same pattern holds true when it comes to the performance of offshore corporate bond versus the aggregate MSCI Investable equity index (including TMT stocks) (Chart 11, bottom panel). The credit cycle leads the business cycle and, thereby, it leads these financial market trends. Bottom Line: The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Chinese offshore corporate bonds will continue underperforming EM corporate bonds as well as Chinese onshore corporate bonds. Investment Recommendations Investors often read market signals across asset classes to gauge which market moves will persist and which ones will be short-lived.  In this regard, we have two observations for Chinese onshore markets: Chart 12Moving In Tandem Moving In Tandem Moving In Tandem The sustainability of an equity rally is higher when it is confirmed by rising excess returns of corporate bonds and rising government bond yields (Chart 12). Presently, there is no strong signal to switch from government bonds to either corporate bonds or stocks. Unfortunately, the yield curve in China does not correlate with its business cycle and, hence, cannot be used as a tool in macro analysis.  Our key investment conclusions are: For fixed-income investors, we continue to recommend receiving 10-year swap rates in China and for dedicated EM local currency bond managers to remain overweight China. The renminbi has been firm versus the US dollar despite a considerable narrowing in the interest rate differential between China and the US. In the long run, the real interest rate differential between China and the US will drive the exchange rate, and it will favor the RMB. While US real bond yields might rise relative to Chinese bond yields in the coming months, triggering a period of yuan softness, it will prove to be transitory. The basis is that the Federal Reserve is very sensitive to asset prices. As US share prices decline and corporate spreads widen, the central bank will eventually turn dovish and will lag behind the inflation curve. When a central bank falls behind the inflation curve, real rates stay low and its currency depreciates. Chart 13China’s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio For domestic asset allocators, we continue to recommend favoring government bonds over stocks (Chart 13). Within fixed-income portfolios, investors should overweight government bonds over corporate bonds. Finally, corporate bonds will fare better than equities in the near term. In a few months there will be an opportunity to shift these positions.  More aggressive stimulus from authorities and aggressive property market relaxation measures will create conditions for an improvement in domestic demand. Finally, the risk-reward profile for offshore USD corporate bonds remains unattractive. Chinese offshore corporate credit will continue underperforming EM USD corporate credit as well as Chinese onshore corporate bonds.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    Due to the lack of excess return data from the index provider (Bloomberg Barclays onshore bond indexes), we calculated the excess return on onshore corporate bonds as the ratio of the total return on the corporate bond index divided by the total return on the government bond index. This measure is not ideal as it does not account for duration mismatches between the corporate and government bond indexes. However, the key conclusions of this report will hold true for the duration-adjusted excess return not least because this framework is valid for financial markets in the US and Europe. 2    The reason to compare it to non-TMT (technology, media and telecommunication, i.e., Chinese tech and internet stocks) is that offshore corporate bond issuers are largely old economy industries.

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (February 15 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET). 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

Feature This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook – a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the last quarter of 2021 were mixed, with business credit standards easing in the US, Japan, Canada, and New Zealand while remaining mostly unchanged in the euro area and UK (Chart 1). Supply chain disruptions have had a two-pronged effect on borrowing. While they have hurt business confidence and prospects, they have also created loan demand as firms look to replenish depleted inventory stocks. The overall picture is one of solid economic fundamentals that are nonetheless perturbed by inflation concerns and lingering uncertainty regarding Covid-19 infections. Chart 1Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice-versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q4/2021 (Chart 3). This marks the fourth consecutive quarter of easing standards. However, banks did report a slower pace of easing, which correlates with tighter financial conditions on the margin (top panel). While we are still in a period of easy financial conditions in absolute terms, this could soon start to change as hot inflation prints and booming economic data cause the Fed to turn increasingly hawkish. Despite this, banks expect to ease standards further over 2022, indicating confidence that underlying economic fundamentals and corporate health will be able to weather monetary tightening. US banks also reported stronger C&I loan demand from all firms in Q4, marking three consecutive quarters of improvement (middle panel). The picture was optimistic, with banks attributing increased loan demand to inventory financing, mergers & acquisitions, and fixed investment. Meanwhile, only 4.2% and 12.5% of banks saw a decrease in internal funds and increasing precautionary demand, respectively, as somewhat important. Inventories accounted for all but 2% of the 6.9% annualized GDP growth in Q4. With inventory stocks still depressed in absolute terms, we expect inventory restocking will continue to buoy demand over 2022. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions ​​​​​ Chart 4US Loan Demand Outlook For 2022 Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? On the consumer side, banks reported easier standards across the board, with standards easing for credit card, auto, and other consumer loans (bottom panel). However, the pace of easing, which has historically been good at calling turning points in consumer confidence (on a rate-of-change basis), appears to have peaked. Consumer sentiment has already been battered by rampant inflation and falling real wage expectations; tighter credit standards down the road could prove to be a further headwind. As part of the one-off special questions in this edition of the survey, respondents were asked about the reasoning behind their outlook for loan demand over 2022 (Chart 4). Of those that expected higher demand, 70% cited higher spending and investment demand from borrowers as their income prospects improved. Meanwhile, only 33% thought that precautionary demand for liquidity would be a factor. Lenders thought that both, a worsening or an improvement in supply chain disruptions, could contribute to increased demand. 53% expected that continued disruption would create greater inventory financing needs. Meanwhile, 55% expected that easing supply chain troubles would boost demand as product availability concerns faded. Of those that expected weaker loan demand, interest rates were by-and-large the biggest factor, with an overwhelming 96% believing that rising rates would quell loan demand. This was followed by concerns that supply chain disruptions would keep prices high and product availability scarce (70%). On the whole, the responses capture a US economy that is at a tipping point, with market participants watching to see how it weathers an aggressive rate hiking cycle from the Fed. While underlying economic variables such as growth and employment remain strong, it still remains to be seen how much of a tightening in financial conditions the markets can bear. Euro Area In the euro area, banks on net reported a very slight tightening of standards to enterprises for the second consecutive quarter in Q4/2021 (Chart 5). Effectively, standards were unchanged as 96 of the 100 respondents to the survey reported no change from Q3. Slightly lower risk tolerance from banks contributed to tightening while lower risk perceptions related to the general economic outlook and the value of collateral had an easing effect. As in the US, standards in the euro area do show a correlation to overall financial conditions. Those have already tightened noticeably since the February 3rd meeting of the European Central Bank (ECB) Governing Council where President Lagarde set a more hawkish tone. While banks do expect a slight easing of standards over Q1/2022, that is unlikely given high inflation and geopolitical uncertainties which will negatively impact risk perceptions. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions ​​​​​​ Chart 6Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies ​​​​​​ Loan demand growth from enterprises was remarkably strong in Q4, with 18% of firms reporting increased demand for loans (middle panel). The main driver was increased demand for inventories, followed closely by fixed investment and merger & acquisition needs. Loan demand leads realized growth in inventories, which has been already been picking up. In Q1, banks expect continued growth in loan demand, albeit at a slower pace. On the consumer side, however, loan demand only increased slightly, with the pace of growth slowing from the previous quarter (bottom panel). This was in line with consumer confidence taking a hit from rising inflation and the Omicron variant in the fourth quarter. The generally low level of interest rates had a small positive impact, while durable goods spending had a slight negative impact on consumer credit demand. Lenders expect moderate growth in consumer credit demand in Q1. Moving to the four major euro area economies, demand for loans to enterprises picked up in Germany, France, and Italy, while remaining unchanged in Spain (Chart 6). Fixed investment needs made a positive contribution across the board. This is corroborated by data on total lending, which is still growing on a year-on-year basis, even though the pace of growth is slowing in all the major euro area economies except Spain. UK In the UK, overall corporate credit standards eased slightly in Q4/2021, marking the fourth straight quarter of easing (Chart 7). However, there was dispersion along firm size. Large private non-financials accounted for all the easing and standards for small and medium firms actually tightened slightly. Going forward, lenders expect a further easing in standards in Q1, about on par with the easing seen in Q4. Chart 7UK Credit Conditions UK Credit Conditions UK Credit Conditions ​​​​​ Chart 8UK Lenders Expect A Robust Growth To Ease Credit Availability Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? ​​​​​​ On the demand side, lenders reported slightly weaker corporate demand for lending in Q4. Again, the results were uneven across firm size – loan demand from large firms strengthened moderately, while demand from small and medium firms weakened. On average, lenders expect a slight pickup in corporate demand over Q1. Moving to the UK consumer, demand for unsecured lending continued to rise at a brisk pace, hovering around the highest levels since Q4/2014 (bottom panel). Going forward, lenders expect a continued increase in demand, but at a much slower pace. The strong developments in loan growth are seemingly at odds with the GfK consumer confidence index which has declined a total of 12 points since its July peak. Although the Bank of England does not survey respondents on the factors driving household unsecured lending demand, the divergence between confidence and loan demand suggests that precautionary demand for liquidity is playing a role. This lines up with the GfK survey, where expectations for the general economic situation over the next year are in freefall with consumers bracing for high inflation and further Bank Rate increases. Pivoting back to the drivers of corporate lending, the leading factor behind increased credit availability was an improvement in the overall economic outlook, followed by market share objectives (Chart 8). In contrast to the UK consumer, lenders are bullish on the economic outlook and believe it will continue to drive further easing over Q1/2022. On the demand side, investment in commercial real estate, which has seen steady improvement since Q3/2020, was the leading factor. This was followed by merger & acquisition and inventory financing needs. Capital investment needs, meanwhile, were a drag on demand. Moving forward, real estate investment and inventory restocking needs are expected to drive demand. Japan In Japan, credit standards to firms and households continued to ease in Q4/2021 (Chart 9). However, more than 90% of respondents in each case reported that standards were basically unchanged, and there were no reported instances of tightening among the sample of 50 lenders. Those that did report easier standards cited aggressive competition from other banks and strengthened efforts to grow the business. The vast majority of lenders expect standards to remain unchanged over Q1, but there is a slight easing expected on a net percentage basis. Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Business loan demand on the whole was unchanged in Q4 although small and medium firms did increase demand slightly (middle panel). In contrast to other regions, business loan demand tends to behave counter-cyclically in Japan, with businesses borrowing more on a precautionary basis when they are pessimistic and vice-versa. Those dynamics were at play in Q4, with lenders attributing increased demand to a fall in firms’ internally generated funds. Banks expect a slight net pickup in demand next quarter, in line with business confidence which has fallen from its September peak on the back of concerns about Covid-19 infections, supply chain disruptions, and rising input prices. On the consumer side, loan demand was basically unchanged, with a very small net percentage of banks reporting weaker demand (bottom panel). The key reason for decreased demand was a decrease in household consumption, which is in line with retail sales, where the pace of growth has been falling. Even though core inflation in Japan is low, consumers are still exposed to rising energy prices, which might cause them to tighten other parts of their budgets. Canada Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions In Canada, business lending standards continued to ease at a slightly slower pace in Q4/2021 (Chart 10). This marks the fourth consecutive quarter of easing conditions, coming amid booming economic activity, high capacity utilization, and buoyant sentiment. Both, price and non-price lending conditions eased at roughly the same pace. On the consumer side, non-mortgage lending conditions continued to ease, but at a slower pace (middle panel). 1-year ahead consumer spending growth expectations, sourced from the Bank of Canada’s (BoC) Survey Of Consumer Expectations, and non-mortgage lending conditions typically display an inverse correlation, with expected spending growth increasing when standards are getting easier on the margin and vice-versa. The divergence in Q4 is explained in part by excess savings accumulated during the pandemic that have yet to be spent down, and in part by expected price increases over the coming year. In either case, it demonstrates that nominal spending has room to grow even in an environment where consumer credit availability is worsening. We also saw mortgage standards ease at a slightly slower pace in Q4, with both price and non-price lending conditions easing (bottom panel). While the BoC has made a hawkish pivot, underlying conditions are still easy – the conventional 5-year mortgage rate is still flat at 4.79%, the same level as Q3/2020. However, house price growth has peaked, and rate hikes this year will help prices moderate further. New Zealand Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions In New Zealand, business credit standards eased in the six month period ended September 2021 (Chart 11). However, the real impact of the Reserve Bank of New Zealand’s (RBNZ) tightening is being felt in the housing market, where actual standards entered tightening territory. More importantly, a net 23.1% of respondents expect mortgage credit availability to erode by the end of March; if realized, this figure would be a series high. Banks reporting less credit availability cited regulatory changes and risk perceptions. On the mortgage loan demand side, banks continued to see increased demand even after the record spike in March 2021 (middle panel). Going forward, demand is expected to moderate and fall from current levels. These dynamics have already made their mark on house prices which have already peaked, indicating that the RBNZ’s push is working as intended. Business loan demand does not appear to have been much affected by higher rates, with demand picking up slightly and expected to increase going forward (bottom panel). However, confidence has been falling since September 2021, with businesses feeling the twin bite of supply chain disruptions and labor shortages.   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1      The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights A feedback loop has emerged in European markets. Tightening financial conditions will preempt the European Central Bank from hiking rates as much as the money market is pricing in. The widening in peripheral and credit spreads is overdone. Investors already long should maintain their positions. Investors without exposure will soon find an attractive entry point. Despite these near-term gyrations, the ECB is still on track to hike interest rates once in Q4 2022 and lift them aggressively in 2023. Feature Last week’s hawkish pivot by the European Central Bank (ECB) continues to affect markets. We take the words of the ECB at their face value; we anticipate the Governing Council (GC) to begin lifting interest rates at the end of 2022 and to continue to do so steadily over 2023 and 2024. However, as the shock filters through financial asset prices, we become more confident that the ECB will not lift rates five times in 2022 as the Euro Short Term Rate (ESTR) curve currently anticipates. Chart 1Growing Tensions In The Periphery... Growing Tensions In The Periphery... Growing Tensions In The Periphery... First, the behavior of Italian and Greek bond markets constitutes a major support to our view. Italian and Greek 10-year spreads have widened by respectively 46 and 65 basis points over the past six trading days (Chart 1). This tension highlights that investors still view these economies as continental trouble spots. Meanwhile, the ECB’s communication continues to highlight the need for flexibility to maintain order in the sovereign debt market. The GC does not want inadvertently to engineer a severe tightening in financial conditions in the already fragile periphery. In this context, it is highly unlikely that the ECB will rush to terminate the Asset Purchase Program (APP), an end on which rate hikes depend. Second, the corporate bond market is also going through a significant period of ruction. Both investment grade and high-yield bond yields have risen rapidly in recent days, and they are now retesting their late-2018 levels (Chart 2, top two panels). Spreads too are widening meaningfully, even though they remain further away from their 2018 highs (Chart 2, bottom two panels) The ECB is unwilling to let a liquidity shock morph into a solvency problem for European firms. For now, the behavior of the European credit market remains consistent with a liquidity shock. Funding markets are experiencing a violent adjustment, which is bleeding into the overall level of spreads. However, investors are not differentiating based on credit risk. Chart 3 shows that CCC credit (the lowest rated HY bonds) is not selling off relative to the overall high-yield index, which we would anticipate if investors were worried about underlying default risk. Chart 3No Distinction On Credit Risk No Distinction On Credit Risk No Distinction On Credit Risk Chart 2...And In European Corporates ...And In European Corporates ...And In European Corporates If the liquidity shock were to deepen further and last long enough, the resilience of the corporate sector would fritter away. However, the GC has tried to resist a deflationary shock for more than ten years now, and a solvency problem would undo all the progress made toward escaping the European liquidity trap, especially because wages have yet to recover. Third, members of the ECB’s GC are already trying to talk down the market. President Christine Lagarde displayed a more dovish tone when she spoke in front of the EU Parliament on February 7, 2022. ECB Chief Economist Philippe Lane remains steadfast that wages are not yet a problem. The Governor of the Bank of France, François Villeroy de Galhau still sees an imminent peak in CPI, and Olli Rehn, Governor of the Bank of Finland, recently lectured about the need for a gradual normalization of policy. Even hawks like the Bundesbank’s Joachim Nagel or the DNB’s Klaas Knot have gestured toward higher rates, but only toward the end of the year. In this context, we expect credit spreads to begin to narrow again; however, it will likely first require an easing in funding pressures. This is unlikely to happen until US yields form an interim peak. However, as Chart 4 highlights, the Treasury market is becoming extremely oversold. Moreover, a JP Morgan survey shows that its clients are massively short duration. The risk of a pullback in Treasury yields is growing, even if rising inflation and fears of a tighter Fed prevail for now. If US yields were to decline Bunds would likely follow the Treasury market because the ECB is becoming louder that it does not want to tighten financial conditions abruptly. Hence, a pullback in global risk-free yields will be the key to a period of calm in credit spreads, since valuations have improved materially, with the breakeven spreads on investment grade and high-yield bonds moving back to their 43rd and 44th percentiles, respectively (Chart 5). A stabilization in global yields and European spreads should also percolate to the peripheral sovereign bond market and limit the upside to Italian and Greek spreads. Chart 4Oversold Treasurys Oversold Treasurys Oversold Treasurys Chart 5Restoring Value In Corporates Restoring Value In Corporates Restoring Value In Corporates Bottom Line: The tightening in financial conditions taking place in Europe indicates that money market curves are pricing in the path for European policy rates too aggressively. The ECB has changed since 2011. It will not let peripheral borrowing costs threaten the recovery in Southern European economies, nor will it allow a liquidity shock in the corporate bond market to become a solvency issue that will damage growth prospects. European peripheral and corporate spreads will narrow once global risk-free rates peak.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Highlights Chart 1Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Most Sectors Have Fully Recovered Last week’s January employment report shocked markets by showing much greater job gains than had been anticipated. More important than the headline number, however, were the revisions to prior months that reveal a much different picture of the post-COVID labor market. In overall terms, the revised data show that employment is still significantly below where it was prior to the pandemic. Specifically, the economy is still missing about 2.9 million jobs. However, the data now reveal that more than 60% of the missing jobs come from the Leisure & Hospitality sector and that the Health Care and State & Local Government sectors account for the rest. In other words, except for the few sectors that have been most impacted by the pandemic, the US labor market has made a full recovery (Chart 1). The new data justify the Fed’s recent push toward tightening. This is because there is no longer any evidence of labor market slack beyond what we see in the select few close-contact service industries that have been most impacted by COVID. Investors should maintain below-benchmark portfolio duration as the Fed moves toward rate hikes. Feature Table 1Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Table 2Fixed Income Sector Performance The COVID Labor Market The COVID Labor Market Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 115 basis points in January. The index option-adjusted spread widened 14 bps on the month to reach 108 bps, and our quality-adjusted 12-month breakeven spread moved up to its 15th percentile since 1995 (Chart 2). This indicates that, despite the recent selloff, corporate bonds remain expensive. We discussed the intermediate-term outlook for corporate bonds in a recent report.1  Specifically, we analyzed the performance of both investment grade and high-yield corporate bonds during previous Fed tightening cycles. Our conclusion is that it will soon be appropriate to reduce our cyclical exposure to corporate credit. For investment grade corporates, this will mean reducing our recommended allocation from neutral (3 out of 5) to underweight (2 out of 5). Our analysis of past cycles suggests that the slope of the yield curve is a critical indicator of corporate bond performance. Excess corporate bond returns are generally strong when the 3-year/10-year Treasury slope is above 50 bps but take a step down when the slope shifts into a range of 0 – 50 bps. The 3/10 slope has just recently dipped below 50 bps (bottom panel). Though our fair value estimates can’t rule out a near-term bounce back above 50 bps, this will become less and less likely as Fed rate hikes approach. We maintain our current recommended allocation for now but expect to downgrade within the next few weeks. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The COVID Labor Market The COVID Labor Market Table 3BCorporate Sector Risk Vs. Reward* The COVID Labor Market The COVID Labor Market High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 158 basis points in January. The index option-adjusted spread widened 59 bps in January to reach 342 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 – also moved up to 4% (Chart 3). The odds are good that defaults will come in below 4% during the next 12 months, which should coincide with the outperformance of high-yield bonds versus Treasuries. For context, the high-yield default rate came in at 1.24% in 2021 and we showed in a recent report that corporate balance sheets are in excellent shape.2 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). While high-yield valuations are more favorable than for investment grade, the bonds will still have to contend with a more challenging monetary environment this year as the Fed lifts rates and the yield curve flattens. For this reason, we expect to reduce our recommended allocation to high-yield corporates in the coming weeks – from overweight (4 out of 5) to neutral (3 out of 5) – though we will retain our preference for high-yield over investment grade. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in January. The zero-volatility spread for conventional 30-year agency MBS tightened 7 bps on the month, split between a 17 bps tightening of the option-adjusted spread (OAS) and a 10 bps 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.3 This valuation picture is starting to change. The option cost is now up to 36 bps, its highest level since March 2020, and refi activity is slowing as the Fed moves toward rate hikes. At 23 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. We continue to recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Emerging Market Bonds (USD): Overweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview This week we officially initiate coverage of USD-denominated Emerging Market (EM) bonds. To start, we will focus on investment grade rated Sovereigns, Corporates and Quasi-Sovereigns. We plan to expand our coverage to include high-yield in the coming months. This EM section replaces the previous Government-Related section in our monthly summary. We will continue to cover Government-Related securities from time to time, but that sub-index will no longer be regularly included in our recommended portfolio allocation. Emerging Market bonds underperformed the duration-equivalent Treasury index by 88 basis points in January. EM Sovereigns underperformed the Treasury benchmark by 134 bps on the month and the EM Corporate & Quasi-Sovereign Index underperformed by 58 bps. After strong relative performance in the back-half of 2021, the EM Sovereign index eked out just 4 bps of outperformance versus the duration-equivalent US corporate bond index in January (Chart 5). Meanwhile, the EM Corporate & Quasi-Sovereign index outperformed the duration-matched US corporate index by 24 bps on the month. Yield differentials for EM sovereigns and corporates remain attractive relative to US corporates (panel 4). Additionally, EM currencies are hanging in there versus the dollar even as the Fed moves toward tightening (bottom panel). We recommend an overweight allocation to USD-denominated EM bonds in US bond portfolios, and we maintain our preference for EM sovereign and corporate bonds relative to US corporates with the same credit rating and duration. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 121 basis points in January (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.4 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 19% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk as bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in January, and yields continued their sharp rise through the first week of February – though in a more parallel fashion. All in all, the 2-year/10-year Treasury slope has flattened 17 bps since the end of December, bringing it to 62 bps. The 5-year/30-year slope has flattened 19 bps since the end of December, bringing it to 45 bps. The aggressive flattening of the curve has occurred alongside the Fed’s increased near-term hawkishness. Our 12-month discounter has risen from 77 bps at the end of last year to 149 bps today (Chart 7). In other words, the market has gone from anticipating just over three 25 basis point rate hikes during the next 12 months to nearly six! Last week’s report argued that the most recent move to discount more than four 25 basis point rate hikes in 2022 is overdone.5  We contend that tightening financial conditions and falling inflation expectations will cause the Fed to moderate its pace of rate hikes in the second half of this year. We still see the Fed lifting rates three or four times in 2022, but this is now significantly below what’s priced in the market. Given our view, we recommend a position long the 2-year Treasury note versus a barbell consisting of cash and the 10-year note. This trade will profit as a more moderate expected pace of near-term rate hikes limits the upward pressure on the 2-year yield. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 23 basis points in January. The 10-year TIPS breakeven inflation rate has declined by 16 bps since the end of December while the 2-year TIPS breakeven inflation rate has fallen by 1 bp. The 10-year and 2-year rates currently sit at 2.43% and 3.21%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate is down 22 bps since the end of December. It currently sits at 2.05%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given how the market has reacted to the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in January. Aaa-rated ABS outperformed by 19 bps on the month and non-Aaa ABS outperformed by 20 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. 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: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in January. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in January, but non-Aaa Non-Agency CMBS outperformed by 2 bps (Chart 10). Though returns have been strong and spreads remain relatively wide, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in January. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Appendix A: 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 January 31, 2022) The COVID Labor Market The COVID Labor Market 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 January 31, 2022) The COVID Labor Market The COVID Labor Market 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 -53 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 53 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 COVID Labor Market The COVID Labor Market Appendix B: 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 11Excess Return Bond Map (As Of January 31, 2022) The COVID Labor Market The COVID Labor Market Recommended Portfolio Specification The COVID Labor Market The COVID Labor Market Other Recommendations The COVID Labor Market The COVID Labor Market Ryan Swift US Bond Strategist rswift@bcaresearch.com    Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Corporate Bond Market”, dated January 25, 2022. 2 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 5 Please see US Bond Strategy Weekly Report, “The Best Laid Plans”, dated February 1, 2022.

Highlights Corporate Bond Returns & Fed Tightening: Corporate bond performance varied considerably during the past four Fed tightening cycles. Our analysis of these periods suggests that valuations and the slope of the yield curve are the two most important factors to monitor. Investment Grade Strategy: Given tight valuations, our analysis of past Fed tightening cycles suggests that it will make sense to downgrade our allocation to investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) once we are confident that the yield curve has shifted into a flatter regime. High-Yield Strategy: De-risking will also be warranted in the high-yield space as the yield curve flattens, but relative valuations dictate that investors should retain a preference for high-yield over investment grade corporates. Feature It is now apparent that the Federal Reserve intends to kick off the next rate hike cycle at the March FOMC meeting. This move has been strongly hinted at in recent Fed speeches and it will be telegraphed more officially when Jay Powell addresses the media tomorrow. In preparation for upcoming rate increases, last week’s report looked at Treasury returns during prior periods of Fed tightening.1 This week, we extend that analysis to the corporate bond market. Specifically, we consider the excess returns that were earned by both investment grade and high-yield corporates during the four most recent rate hike cycles.2 We conclude that a defensive posture toward credit risk will be warranted as Fed tightening gets underway. While we aren’t quite ready to downgrade our recommended allocation to corporate bonds today, we expect to do so within the next couple of months. Corporate Bond Returns During Rate Hike Cycles Table 1 presents excess returns for both the Bloomberg Barclays Investment Grade Corporate Bond Index and the Bloomberg Barclays High-Yield Corporate Bond Index in each of the past four Fed tightening cycles. As was the case last week, we define each tightening cycle as spanning from the first rate hike until the last rate hike. We also exclude periods such as 1997 when the Fed only lifted rates once before reversing course. Table 1Corporate Bond Returns During Fed Rate Hike Cycles Positioning For Rate Hikes In The Corporate Bond Market Positioning For Rate Hikes In The Corporate Bond Market Our first preliminary conclusion is that (unlike with Treasury returns) there is not much commonality between the different cycles. For example, corporate excess returns were quite strong during the 2015-18 cycle and very weak during the 1999-2000 cycle. In other words, it’s even more important to examine each cycle individually to get a sense of how we should position in the corporate bond market today. The 2015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target rate by 225 bps. Investment grade corporate bond returns were quite strong during this period (Chart 1A), and there is one major reason why. The start of the tightening cycle happened to coincide with the peak of a default cycle. As a result, corporate spreads were elevated when hiking began and they tightened rapidly throughout 2016 and 2017 (Chart 1A, panel 3). Spread tightening in 2016 and 2017 was helped along by an accommodative policy environment, as evidenced by the fact that the yield curve remained steep (3/10 slope > 50 bps) during those years (Chart 1A, panel 4). It’s notable that returns turned negative in 2018, only after the average index spread moved below 100 bps and the Treasury slope moved below 50 bps. In other words, corporate bond returns were strong early in the cycle but turned negative once value evaporated and the monetary backdrop became less accommodative. High-Yield returns show a similar pattern to investment grade (Chart 1B). Spreads started out very wide in early-2016 and tightened rapidly until monetary conditions turned more restrictive in 2018. Our Default-Adjusted Spread is an additional valuation tool for high-yield bonds (Chart 1B, panel 4). This is calculated as the average index spread less the actual default losses that were experienced during the subsequent 12 months. Our research has shown that high-yield bonds usually outperform Treasuries during 12 month periods in which the Default-Adjusted Spread is above 100 bps (see the Appendix of this report for more details). In this case, the Default-Adjusted Spread was an extremely high 258 bps at the beginning of the tightening cycle and it didn’t dip below 100 bps until after rate hikes ended. Chart 1A2015-2018 Cycle: Investment Grade 2015-2018 Cycle: Investment Grade 2015-2018 Cycle: Investment Grade Chart 1B2015-2018 Cycle: High-Yield 2015-2018 Cycle: High-Yield 2015-2018 Cycle: High-Yield   The 2004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span. Excess investment grade corporate bond returns were close to zero during this cycle (Chart 2A). Unlike in 2015, corporate spreads started out at tight levels (below 100 bps), though the accommodative monetary environment – as evidenced by the steep yield curve – allowed them to tighten somewhat during the first year of Fed hiking. However, spreads then reverted closer to 100 bps in 2005 as the yield curve flattened to below 50 bps (Chart 2A, panel 4) and the policy backdrop turned more restrictive. Junk bonds performed extremely well during the 2004-06 cycle (Chart 2B), and once again this is due to very attractive starting valuations. The average High-Yield Index spread was 384 bps on the day of the first hike in 2004, compensation that turned out to be astoundingly high when you consider that monthly default events were in the low single digits throughout the entire period (Chart 2B, bottom panel). As was the case in the 2015-18 cycle, our Default-Adjusted Spread measure never dipped below 100 bps. In fact, it troughed at 145 bps in early 2005 (Chart 2B, panel 4). Chart 2A2004-2006 Cycle: Investment Grade 2004-2006 Cycle: Investment Grade 2004-2006 Cycle: Investment Grade Chart 2B2004-2006 Cycle: High-Yield 2004-2006 Cycle: High-Yield 2004-2006 Cycle: High-Yield The 1999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5%. Excess investment grade corporate bond returns were poor during this period (Chart 3A), the combination of relatively low starting spreads and a very flat yield curve that even inverted in early 2000 (Chart 3A, panels 3 & 4). High-yield excess returns were even worse than for investment grade (Chart 3B). While, at the onset of Fed tightening, junk spreads were quite elevated in absolute terms (Chart 3B, panel 3), they turned out to be too low compared to the magnitude of default losses that occurred throughout 1999 and 2000 (Chart 3B, bottom panel). Our Default-Adjusted Spread measure started the cycle below 100 bps and then dipped into negative territory in early 2000 (Chart 3B, panel 4). Chart 3A1999-2000 Cycle: Investment Grade 1999-2000 Cycle: Investment Grade 1999-2000 Cycle: Investment Grade Chart 3B1999-2000 Cycle: High-Yield 1999-2000 Cycle: High-Yield 1999-2000 Cycle: High-Yield The 1994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995. This cycle coincided with modestly positive excess returns for investment grade corporates (Chart 4A). The average index spread began the cycle at the extraordinarily tight level of 67 bps (Chart 4A, panel 3). However, unappealing valuations were counteracted by the accommodative monetary environment, as evidenced by a yield curve slope that didn’t dip below 50 bps until the Fed was almost done hiking (Chart 4A, panel 4).    Junk returns were also modestly positive during this period (Chart 4B). Spreads started the cycle at attractive levels (Chart 4B, panel 3) and the default rate was on the downswing (Chart 4B, bottom panel). Junk spreads, however, were mostly rangebound during the period of Fed tightening. Chart 4A1994-1995 Cycle: Investment Grade 1994-1995 Cycle: Investment Grade 1994-1995 Cycle: Investment Grade Chart 4B1994-1995 Cycle: High-Yield 1994-1995 Cycle: High-Yield 1994-1995 Cycle: High-Yield Investment Implications Investment Grade Our analysis of past cycles reveals that valuation and the slope of the yield curve are the two most important factors to consider when assessing the potential for investment grade corporate bond excess returns during a Fed tightening cycle. The 2015-18 period of strong investment grade returns coincided with elevated spreads and a yield curve slope that stayed above 50 bps for the first two years of tightening. In contrast, the 1999-2000 period of negative corporate returns was driven by expensive starting valuations and a very flat curve. Today, investment grade corporate bond valuations are about as expensive as they’ve ever been. The average index option-adjusted spread (OAS) is currently 100 bps, the index OAS has been tighter than this level 40% of the time since 1995 (Chart 5). This does not appear terrible at first blush, but we must also consider that the risk characteristics of the index have changed during the past few decades. Specifically, the index’s average credit rating is lower, and its average duration is higher. If we adjust the index to maintain a constant credit rating through time, we see that the spread falls from its 40th percentile to its 28th percentile (Chart 5, panel 2). If we then adjust for the changing duration of the index by looking at the 12-month breakeven spread instead of the OAS, we see the spread fall to its 7th percentile since 1995 (Chart 5, bottom panel).3 As for the yield curve, the 3-year/10-year Treasury slope is currently very close to 50 bps – the threshold that roughly represents the transition from an accommodative monetary environment to a more neutral one (Chart 6). Given expensive starting valuations, our inclination is to reduce our investment grade corporate bond exposure once we are confident that the 3/10 slope will remain below 50 bps for the remainder of the cycle. We think we are close to reaching that point, but we aren’t quite there yet. Our estimates based on a range of plausible scenarios for Fed tightening suggest that the 3/10 slope will permanently move below 50 bps in the coming months, by July at the very latest. When that occurs, we will reduce our recommended corporate bond exposure from neutral (3 out of 5) to underweight (2 out of 5). Chart 6Watch The Treasury Slope Watch The Treasury Slope Watch The Treasury Slope Chart 5IG Valuation IG Valuation IG Valuation High-Yield The valuation picture for high-yield is somewhat more pleasant than for investment grade. The OAS differential between the high-yield and investment grade indexes is fairly tight, at its 15th percentile since 1995 (Chart 7). However, this differential rises to the 36th percentile when we adjust for the duration differences of the indexes by using the 12-month breakeven spread. Chart 7HY Valuation HY Valuation HY Valuation Applying our Default-Adjusted Spread methodology to today’s junk market, we estimate that the Default-Adjusted Spread will come in above the crucial 100 bps threshold as long as the default rate is 3.5% or lower during the next 12 months (Chart 7, bottom panel). This seems quite likely given the current strong state of corporate balance sheets.4 All that said, the evidence from past cycles suggests that a more defensive posture toward high-yield corporates will also be warranted once we are confident that the 3/10 slope has permanently moved below 50 bps. However, relative valuation dictates that we should still retain a preference for high-yield over investment grade even as we get more defensive overall. Our next move will likely be to downgrade high-yield from overweight (4 out of 5) to neutral (3 out of 5). Some Thoughts On Credit Investment Strategy The above analysis of corporate bond performance shows that it is generally weaker once the yield curve has flattened into a range of 0 – 50 bps. However, that move alone doesn’t guarantee negative excess corporate bond returns. In fact, it is quite plausible that the slope could remain within a 0 – 50 bps range for a long time even as the Fed tightens, and that corporate bonds could still deliver small positive excess returns versus Treasuries. However, we must acknowledge that the risks of Fed overtightening, curve inversion and economic recession increase as the yield curve flattens. We must also acknowledge that current valuations suggest that future excess returns will be small, even if they are positive. For example, if we assume that the average investment grade OAS can’t tighten very much from current levels, then the best we can expect is 100 bps per year of excess return. Meanwhile, 100 bps of spread widening – much less than you would expect in a default cycle – would lead to losses of roughly 850 bps. In other words, it will be profitable to exit investment grade corporate bond positions today as long as the next bout of 100 bps of spread widening occurs within the next 8.5 years (Table 2). The risk/reward trade-off clearly favors a more defensive credit allocation. Table 2The Risk/Reward Trade-off In Corporate Bonds Positioning For Rate Hikes In The Corporate Bond Market Positioning For Rate Hikes In The Corporate Bond Market Interestingly, Table 2 shows that the risk/reward math is more favorable for junk bonds. Depending on our default loss assumptions, the 8.5 years we calculated for investment grade falls to a range of 1.8 to 3 years for high-yield. Bottom Line: Tight valuations and low expected returns suggest that investors should be more cautious on credit risk this cycle. In our view, it is advisable to reduce credit risk allocation earlier than usual this cycle in order to ensure that you aren’t invested during the next big selloff. Appendix Image Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Treasury Market”, dated January 18, 2022. 2 We define excess returns as the excess returns earned by the corporate bond index relative to a duration-matched position in US Treasuries. 3 The 12-month breakeven spread can be thought of as the spread widening required for the index to break even with duration-matched Treasuries on a 12-month investment horizon. It can be approximated as OAS divided by duration. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights On US inflation and the Fed: If the Fed adheres to its mandate, it has no choice but to hike rates until core inflation drops toward 2% (from its current level above 4%). Yet, share prices will sell off before inflation converges toward the Fed’s target. On US TIPS yields: Rising TIPS yields will depress share prices in the richly valued equity markets like the US, support the greenback, and curtail portfolio flows into EM for a period of time. On China: Despite stimulus, China’s business cycle will continue disappointing over the near-term. Besides, a bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. On financial market divergences: Major selloffs evolve in phases resembling domino effect-like patterns. In contrast, corrections are abrupt, and the majority of markets drop concurrently. Hence, the nature of current market dynamics is more consistent with a major selloff than a short-term correction. On regional allocation within a global equity portfolio: Overweight the euro area and Japan, underweight the US and EM. Feature Ms. Mea is a long-time BCA client and an avid follower of the Emerging Markets Strategy (EMS) service. Since 2017, I have been meeting with her twice a year to exchange thoughts on the global macro environment, to discuss the nuances of our views and to elaborate on investment strategy. We always publish our conversations for the benefit of all EMS clients. This virtual meeting took place earlier this week. Chart 1A Technical Breakout Is In US Bond Yields A Technical Breakout Is In US Bond Yields A Technical Breakout Is In US Bond Yields Ms. Mea: It has been two years since we last met in person. I did not imagine that world travel would stay so depressed for so long when the pandemic began two years ago. I have also been surprised by the recent behavior of financial markets. There have been divergences that I cannot reconcile, such as the woes in China’s real estate sector and resilient commodity prices, the diverging performance of the S&P 500, US small caps and a significant portion of NASDAQ-listed stocks. I will ask you about these later. But let’s start with your main macro themes. Since early last year, you have been advocating two macro themes: (1) China’s slowdown; and (2) rising and non-transitory US inflation. They were controversial a year ago but have now become widely accepted in the investment community. Financial markets have moved a great deal to reflect these macro themes. Don’t you think financial markets have already fully priced in these macro trends? Answer: You are right that these narratives have become well known and financial markets have been moving to price in these developments. However, our bias is that these themes are not yet fully priced in and these macro forces will continue to impact financial markets over the near term. Let’s first discuss US inflation and interest rate moves. Chart 1 illustrates that US government bond yields have broken above major resistance levels. Such a breakout technically entails higher yields. Odds are that US long-term bond yields will move up by another 50 basis points in the months ahead before they pause or reverse. The fundamental justification for higher US bond yields is as follows: The inflation genie is out of the bottle in the US. If the Fed adheres to its inflation mandate, it has no choice but to hike rates until core inflation drops toward 2%. In December, trimmed-mean CPI and median CPI printed 4.8% and 3.8% respectively, well above the Fed’s preferred range of 2-2.25% for core inflation (Chart 2). Critically, these inflation measures are not impacted by volatile components. These measures strip out outliers like used and new car prices, auto parts, as well as energy and food. The core CPI and PCE inflation measures will drop this year but super core inflation will remain north of 3%, well above the Fed’s preferred range. Importantly, a wage inflation spiral is already underway in the US. Employees have experienced substantial negative wage growth in real terms in the past 12 months. Labor shortages are prevalent, and the employee quit rate is very high. Employees are demanding very high wage growth and employers will have little choice but to meet these demands (Chart 3). Chart 2US Super Core Inflation Suggests Broad-Based Inflationary Pressures US Super Core Inflation Suggests Broad=Based Inflationary Pressures US Super Core Inflation Suggests Broad=Based Inflationary Pressures Chart 3US Wages Will Be Accelerating US Wages Will Be Accelerating US Wages Will Be Accelerating Chart 4Rising TIPS Yields = Equity Multiples Comparison Rising TIPS Yields = Equity Multiples Comparison Rising TIPS Yields = Equity Multiples Comparison As a result, the only way to bring down core inflation toward its preferred target range is for the Fed to slow the economy down and curb employment and wage gains. Yet before core inflation converges to the Fed’s target, risk assets will sell off first. Practically, the Fed will talk hawkish and hike until something breaks. The breaking point will be a major selloff in US share prices. US equities have been priced to perfection on the assumption that US interest rates will remain low for many years. As interest rate expectations rise further, US equity multiples are under pressure (Chart 4). Ms. Mea: The recent rise in US bond yields has been largely driven by the real component (TIPS yields), not inflation breakevens. That would usually imply improving US growth prospects. Yet US stocks have corrected as TIPS yields rose. How do you explain this and what should investors expect going forward? Answer: Indeed, the latest rise in US bonds yields is primarily driven by increasing TIPS yields, not inflation breakevens (Chart 5) TIPS yields have not been driven by economic growth expectations in the past couple of years. TIPS yields are breaking out and more upside is likely for reasons unrelated to US economic growth: The Fed’s rhetoric and guidance. TIPS yields typically move with 5-year/5-year forward yields, i.e., expectations for US interest rates in the long run (Chart 6). One of reasons why forward interest rates and TIPS yields have been low is the Fed’s commitment to keep interest rates extremely depressed for so long. As the Fed’s rhetoric has recently changed, so are interest rate expectations and TIPS yields. Given that core inflation will not drop to the Fed’s target range any time soon, the Fed will likely escalate its hawkish rhetoric. Hence, TIPS yields will keep rising, until something breaks. Chart 5US Tips Yields Have Broken Out After A Base Formation US Tips Yields Have Broken Out After A Base Formation US Tips Yields Have Broken Out After A Base Formation Chart 6US TIPS Yields More With Long-Term Interest Rate Expectations US TIPS Yields More With Long-Term Interest Rate Expectations US TIPS Yields More With Long-Term Interest Rate Expectations TIPS demand/supply and momentum. The TIPS market is relatively small, and it has been rigged by the Fed in the past two years or so. As a part of its QE program, the Fed has been buying a large share of TIPS, and it now owns 22% of this market. As a result, TIPS yields have fallen irrespective of economic growth dynamics. As the QE program ends, the Fed will stop purchasing TIPS. There has also been a rush into TIPS by institutional investors. In a quest for inflation protection when the Fed was complacent about inflation, investors have been opting for TIPS. This has also depressed TIPS yields. As the US central bank sounds more hawkish, investors’ demand for inflation protection will likely diminish. In addition, TIPS prices have recently plunged dramatically. Large losses could prompt further liquidation by investors pushing TIPS yields much higher. All of the above and the fact that TIPS yields remain negative suggest that they will continue rising in the coming months. Chart 7Rising TIPS Yields Warrant A Stronger US Dollar Rising TIPS Yields Warrant A Stronger US Dollar Rising TIPS Yields Warrant A Stronger US Dollar Ms. Mea: Your point that TIPS yields will continue rising in the months ahead irrespective of US inflation and growth dynamics is interesting. So, what are the implications of rising US bond yields, especially TIPS yields, on various financial markets? Answer: Falling/low TIPS yields have benefited long duration plays like US stocks, and especially US growth stocks. Declining TIPS yields were a drag on the US dollar (Chart 7). Finally, they also prompted portfolio capital flows to EM. Consistently, rising TIPS yields will depress share prices in the richly valued equity markets like the US (Chart 4, above) support the greenback, and curtail portfolio flows into EM for a period of time. Ms. Mea: But aren’t US share prices positively correlated with US interest rates? Answer: Not always. Chart 8 illustrates that the correlation between the S&P 500 and US Treasury yields varied over time. Prior to the mid-1960s, it was positive. From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields. Since 1997, US share prices have been positively correlated with US government bond yields (Chart 8, top panel). Chart 8US Stock-Bond Correlation: A Paradigm Shift In 2022? US Stock-Bond Correlation: A Paradigm Shift In 2022? US Stock-Bond Correlation: A Paradigm Shift In 2022? Chart 9Early 2020s = Late 1960s? Early 2020s = Late 1960s? Early 2020s = Late 1960s? We believe US markets are now undergoing a major paradigm shift in the stock prices-bond yields correlation. The latter is about to turn negative like it did in the second half of the 1960s. In the mid-1960s, the reason why the stock-to-bond yields correlation turned negative was because US core inflation surged well above 2% in 1966 (Chart 8, bottom panel). This marked a paradigm shift in the relationship between equity prices and US Treasury yields. The same is happening now. As we wrote a year ago in our Special Report titled A Paradigm Shift In The Stock-Bond Relationship, the proper roadmap for the US stock-to-bond correlation is not the last 10 or 20 years, but the second half of the 1960s. After US core CPI surged substantially above 2%, the S&P 500 became negatively correlated with US Treasury yields (Chart 9). Ms. Mea: Let’s now turn to emerging markets. How will EM financial markets perform amid rising US bonds yields? Also, which US yields matter most for EM financial markets, US Treasury yields or TIPS? Answer: Neither US Treasury yields nor TIPS yields have a stable correlation with EM stock prices. Correlations between US nominal bond yields, EM currencies and EM domestic bond yields vary over time. However, US TIPS yields exhibit a reasonably strong positive correlation with mainstream EM local bond yields and the US dollar's exchange rate versus EM currencies (Chart 10). Mainstream EM includes 16 markets but excludes China, Korea and Taiwan. Hence, as US TIPS yields move up, it is reasonable to expect the US dollar to strengthen against mainstream EM currencies and their local bond yields to rise (Chart 10). Currency depreciation and rising domestic bond yields will prove to be toxic for the share prices of these mainstream emerging markets. To sum up, rising US TIPS yields will jeopardize the performance of EM equities, currencies, local rates and credit markets. Ms. Mea: Aren’t many EMs better prepared for rising US nominal/real yields than they were in 2013? Answer: Yes, they are: many EM countries that were running large current account deficits in 2013 now have current account surpluses or small deficits (Chart 11, top panel). Besides, mainstream EMs ramped up their foreign currency debt in the years preceding 2013 while their foreign debt has changed little in the past 6-7 years (Chart 11, bottom panel). Chart 10Rising TIPS Yields Are A Risk To EM Domestic Bonds Rising TIPS Yields Are A Risk To EM Domestic Bonds Rising TIPS Yields Are A Risk To EM Domestic Bonds Chart 11Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Table 1Current Account Balances In Individual EM Countries Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Table 1 illustrates the current account balance in individual developing countries. Further, the share of foreign investor holdings in EM local currency bonds has declined a great deal in the past 2 years (Table 2). Finally, many mainstream EM central banks have hiked rates aggressively and their local bond yields have already risen considerably in the past 12 months. These also provide some protection against fixed-income portfolio capital outflows. All in all, vulnerability from foreign portfolio capital outflows in EM is much lower than it was in 2013. Nevertheless, EM financial markets will not remain unscathed if US rates march higher, the US dollar rallies and US stocks wobble. Based on the parameters displayed in Tables 1 and 2, the most vulnerable countries among mainstream EMs are Peru, Colombia, Chile and Egypt. Table 2Foreign Ownership Of Domestic Bonds: January 2022 Versus October 2019 Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Conversation With Ms. Mea: US Inflation Redux, TIPS And Implications For EM Chart 12China"s Construction Cycle In Perspective China"s Construction Cycle In Perspective China"s Construction Cycle In Perspective Ms. Mea: Let’s now move to your second theme - China’s slowdown. This is well known and arguably priced in financial markets. Importantly, policymakers have been ratcheting up stimulus. Don’t you think now is the time to upgrade the stance on Chinese stocks and China-related plays? Answer: Despite the new round of stimulus, China’s business cycle will continue disappointing over the near-term. As we wrote in last week’s report titled Chinese Equities: Valuations and Profits, Chinese corporate earnings are set to contract in the next 6 months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Importantly, even though property market woes are well known and housing sales and starts have collapsed, housing construction activity has remained resilient (Chart 12). The bottom panel of Chart 12 demonstrates rising completions, which is one of reasons why raw materials prices have been resilient. However, new funding for property developers has dried up and they will be forced to scale back completions/construction activity. Historically, EM non-TMT share prices lagged the turning points in China’s money/credit impulses by several months (Chart 13). Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in a few months. In brief, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Chart 13China"s Credit Cycle And EM Non-TMT Stocks China"s Credit Cycle And EM Non-TMT Stocks China"s Credit Cycle And EM Non-TMT Stocks Ms. Mea: Another topic I wanted to discuss today is divergences in global financial markets. Some equity markets have already fallen significantly, while the S&P 500 index as well as a couple of individual EM equity bourses (India, Taiwan and Mexico) have been firm. There have been massive divergences within the US equity market in general and the NASDAQ index in particular. Besides, EM high-yield corporate spreads have widened but EM investment grade corporate spreads remain tight. Finally, commodity prices have remained firm despite both China’s slowdown and US dollar strength. How should investors interpret these divergences? Answer: Such divergences in financial markets often occur during major selloffs. Notable financial market downturns evolve in phases resembling domino effect-like patterns, where some markets lead while others lag. In contrast, corrections are abrupt, and the majority of markets drop concurrently. For example, the EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then spread to Korea, Malaysia and Indonesia, and finally to the rest of Asia. By August 1998, Russian financial markets had collapsed, triggering the Long-Term Capital Management (LTCM) debacle. The last leg of the crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Chart 14Domino Effect In 2007-08 Domino Effect In 2007-08 Domino Effect In 2007-08 Similarly, the US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 14). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 14, bottom panel). There was a domino effect in financial markets in both the 2015 and 2018 turbulences. Initially, the selloffs started in the weakest links while other parts were holding up. Then, the selloff spread to all without exception. For example, in 2018, US share prices and high-yield credit spreads were doing quite well until October 2018. Then, a broad-based selloff transpired in the fourth quarter of 2018.  Just as chains break at their weakest links, financial market selloffs begin in the most susceptible sectors. Overpriced US stocks with little or no profits and currencies with zero or negative interest rates have been most vulnerable to rising US interest rates. That is why these segments have sold off first in response to rising US nominal and real rates. Our hunch is that the selloff in global markets due to rising US interest rates will broaden in the coming months. This does not mean that global stocks on the verge of a major bear market, but a double-digit drop in global share prices is likely. The last asset class standing will be commodity prices. These will likely be the last affected by rising US interest rates because many investors buy commodities as an inflation hedge. Besides, oil prices have also been supported by the geopolitical tensions around Ukraine and Iran. It might take investor concerns about the US economy and a slowdown in global manufacturing to trigger a relapse in commodity prices. Chart 15Rising TIPS Yields = European Equities Outperforming US Ones Rising TIPS Yields = European Equities Outperforming US Ones Rising TIPS Yields = European Equities Outperforming US Ones Ms. Mea: What investment strategy do you recommend in the coming months? Answer: As US interest rates continue rising and China’s recovery fails to transpire immediately, EM financial markets remain at risk. Therefore, we recommend a defensive stance for absolute return investors in EM equity and fixed income. We are also continuing to short a basket of EM currencies versus the US dollar. As for global equity regional allocation, the outlook for EM performance is less certain than it was in the past 12 months. Clearly, rising US/DM interest rates herald US equity underperformance versus other DM markets, like the euro area and Japan (Chart 15). The basis is that non-US equities are not as expensive as US ones and, hence, are less vulnerable to rising interest rates. Chart 16EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields Whether EM outperforms or not is mainly contingent on the US dollar, rather than US bond yields. The top panel of Chart 16 demonstrates that EM relative equity performance against DM has a low correlation with US bond yields. Yet, EM equities will underperform their DM peers if the USD strengthens (the greenback is shown inverted on the bottom panel of Chart 16). However, if the greenback depreciates, EM will certainly outperform the US in both equity and the fixed income space. Putting it all together, asset allocators should overweight the euro area and Japan, and underweight the US and EM in a global equity portfolio. Ms. Mea: What about EM local bonds and EM credit markets? Answer: EM credit spreads will widen, and EM local yields will not drop as US bond yields head higher and EM exchange rates depreciate. We continue to recommend investors underweight EM credit versus US corporate credit, quality adjusted. As for local rates, we largely remain on the sidelines of this asset class. Our current recommendations are as follows: receiving 10-year rates in China and Malaysia, paying Czech 10-year rates and betting on 10/1-year yield curve inversions in Mexico and Russia. For a detailed list of our country recommendations for equities, credit, domestic bonds and currencies, please refer to Open Position Tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Image Image