Economic Growth

Highlights The number one risk to our upbeat view on European economic activity and assets is a Chinese economic slowdown. The second most important risk to our view is a potential deterioration in the global credit impulse, even outside of China. The third major risk is that the current bout of US inflation proves to be permanent, which, paradoxically, would prompt a deflationary shock for the global economy. Despite these risks, we maintain our favorable view on European assets over the coming 12 to 18 months. However, favoring industrials over materials, and financials over other cyclicals, Swedish equities and peripheral bonds in balanced portfolios mitigate some of these risks. Do not expect the ECB to announce a tapering of its asset purchases at the June meeting. The ECB will lag well behind the Fed and the BoE. Buy European steepeners and US flatteners as a box trade. Feature Over the past three weeks, a sustained marketing push gave us the opportunity to interact intensively with a large subset of our clients (albeit virtually, courtesy of COVID-19). Generally, our positive stance on European assets was well received, but investors are loosely committing themselves to this view and very few are willing to make an aggressive bet on Europe. In fact, in most meetings, we spent more time than usual discussing the risks to our upbeat view on Europe and European cyclical equities. Three risks to our 12- to 18-month view standout. The first is a serious slowdown in Chinese growth. The second is a greater-than-anticipated impact on economic activity as a result of a deterioration in DM credit impulses. The third is stronger-than-expected US inflation. An also-ran was the risk that the current vaccines do not protect against the two variants of the COVID-19 virus dominant in India. However, an increasing body of recent scientific studies demonstrates that this is not the case; hence, this risk has been lowered to minor. Risk #1: A Chinese Slowdown Authorities in China have been constricting credit policy over the past six months. The key tools used have been a regulatory tightening in shadow-banking activities and real estate transactions, moral suasion on small banks to limit the expansion of their loan books, and slowing liquidity injections in the interbank system. Beijing’s policy tightening reflects the following two worries. First, the financial stability risk has increased meaningfully over the past 16 months. China’s corporate debt-to-GDP has increased 13 points to 163%, and is among the highest for major economies (Chart 1). Moreover, Chinese policymakers remain concerned by the middle-income trap, which would become an increasingly likely outcome if the stability of the country’s financial and banking system were compromised. Second, the latest round of stimulus has worsened wealth inequalities. House prices have been robust, yet household disposable income growth is still low by the yardstick of the past 40 years (Chart 2). Thus, a large proportion of China’s population has experienced a decline in housing affordability. Chart 1China"s Financial Stabilitiy Risk China"s Financial Stabilitiy Risk China"s Financial Stabilitiy Risk Chart 2Chinese Households Are Not Doing That Well Chinese Households Are Not Doing That Well Chinese Households Are Not Doing That Well The Chinese economy recently started to feel the impact of the policy tightening. China’s April retail sales data missed expectation by 7.2%, and, as our China Investment Strategy colleagues have observed, the demand side of the economy has lagged behind the recovery in supply ever since China re-opened last year. Credit trends confirm this assessment. The decline in the excess reserve ratio of the Chinese banking system is consistent with the recent deterioration in the credit impulse, which accelerated in April (Chart 3). Since the Great Financial Crisis, weaker Chinese credit flows herald softer global industrial activity and trade (Chart 3, bottom panel). The Chinese slowdown could become a major problem for the European economy and its asset markets. As we recently showed, the sensitivity of European economic activity to global growth has been steadily increasing over the past 20 years (Chart 4). Moreover, the spread between M1 and M2 money supply growth in China best explains the gap between European industrial activity and that of the US (Chart 4, middle and bottom panels). Essentially, M1 minus M2 approximates the Chinese private sector’s marginal propensity to consume, because it captures how fast demand deposits are growing relative to savings deposits. Thus, the recent decline in China’s marginal propensity to consume constitutes a bad omen for European activity and profit growth, both in absolute terms and relative to the US. Chart 3A Policy-Induced Slowdown A Policy-Induced Slowdown A Policy-Induced Slowdown Chart 4Europe Is More Exposed Than The US Europe Is More Exposed Than The US Europe Is More Exposed Than The US The slowdown in China’s economy will hurt European asset prices via multiple channels. Importantly, cyclical stocks are expensive and overbought compared to defensive ones. A meaningful decline in Chinese growth could result in a deep fall in the cyclicals-to-defensives ratio, which would hurt the pro-cyclical EUR/USD exchange rate (Chart 5). A weaker China might also create a significant fall in global yields, because it would hurt global growth, accentuate deflationary forces, and upset investor sentiment. European stocks underperform US equities when global yields decline (Chart 6). Chart 5The Euro Is Pro-Cyclical The Euro Is Pro-Cyclical The Euro Is Pro-Cyclical Chart 6A Key Threat To European Stocks A Key Threat To European Stocks A Key Threat To European Stocks Despite the dire impact that a Chinese economic slowdown normally causes on European growth and assets, this outcome remains a risk and not a base case (albeit, the top risk in our view). First, today is one of the rare occasions when global and European economic activity can decouple from China. The Euro Area’s vaccination campaign is gaining steam, which will allow a re-opening of the economy this summer (Chart 7). The vast pent-up demand in durable goods evident in Europe and the positive impact of the European monetary expansion on the contribution of consumer expenditure to real GDP growth also create powerful offsets (Chart 8). Chart 8European Pent-Up Demand As An Offset European Pent-Up Demand As An Offset European Pent-Up Demand As An Offset Chart 7Improving Vaccine Rollout Improving Vaccine Rollout Improving Vaccine Rollout The global industrial cycle is more buffered than usual against a Chinese economic slowdown. The collapse in the inventory-to-sales ratios around the world will fuel several quarters of restocking, which will boost the global manufacturing sector (Chart 9). Moreover, governments across advanced economies are unleashing large-scale infrastructure plans, such as the $2 trillion bill proposed by the Biden administration in the US or the EUR250 billion budget proposal by the Draghi government in Italy. As the EUR750 billion NGEU funds are disbursed, the tailwind to infrastructure spending will only grow (Chart 10). Additionally, the current spurt in inflation around the world is a relative price shock driven by scarcity created during the pandemic. This price shock incentivizes companies to expand production and capacity to meet demand. As a result, global capex intentions are rising, which will create an additional offset to China. Chart 9Restocking Ahead Restocking Ahead Restocking Ahead Chart 10More Fiscal Support This Way Comes More Fiscal Support This Way Comes More Fiscal Support This Way Comes Finally, constraints on Chinese policymakers limit to how far Chinese growth will decelerate. The Chinese Communist Party Congress, in which the make-up of the politburo is determined for the next five years, takes place in October 2022. However, the weak growth rate of household disposable income creates a headache for China’s leadership. While another round of massive stimulus is unlikely to shore up household disposable income (it has not worked thus far), Beijing will not take the chance to generate another deflationary shock. This constraint creates a natural floor under the growth deceleration that Beijing can tolerate. Thus, while a policy mistake is still possible, it is not our base case scenario. Investment Implication Faced with the aforementioned dynamics, BCA recommends that investors with a short-term investment horizon go neutral on cyclical equities relative to defensive ones. Practically, this means that EUR/USD is likely to continue to churn between 1.18 and 1.235 for the coming two to three months. Additionally, European equities are likely to move sideways relative to their US counterparts over this period. Within cyclical equities, we favor industrials over materials. Commodity prices, and thus the materials sector, are the most exposed to China. Meanwhile, the outlook for infrastructure spending and capex in DM economies has a greater impact on industrial stocks than on materials ones. Technically, industrials remain toward the bottom of their upward-slopping trend channel relative to materials, which suggests further catch up is likely (Chart 11). We also favor European financials over the rest of the cyclical sectors. The negative impact of a greater-than-expected Chinese economic slowdown on global yields will hurt financials. Nonetheless, domestic economic activity affects financials more than it influences the more internationally focused industrials and materials sectors. Thus, if the Eurozone service PMI can slingshot higher, a result of the re-opening of the economy this summer, then European financials will outperform industrials and materials stocks even if the Chinese economy slows (Chart 12). Moreover, financials trade at a large discount compared to these other two cyclical sectors (Chart 12). Chart 11Overweight Industrials Vs Materials Overweight Industrials Vs Materials Overweight Industrials Vs Materials Chart 12Financials As A Protection Against China Financials As A Protection Against China Financials As A Protection Against China Finally, we continue to favor Swedish equities. Industrials and financials account for 65% of the Swedish MSCI benchmark compared to 30% for that of the Euro Area. Therefore, they are particularly exposed to the positive outlook on global infrastructure spending and capex. Moreover, Swedish equities generate a return on equity of 15%, compared to 6% for the Eurozone stocks. To protect against the risk created by a weakening Chinese economy, we recommend investors hedge a long / overweight bet on Sweden with a short / underweight position in Norwegian equities that massively over-represent energy and materials. Risk #2: A Global Credit Impulse Deterioration According to the BIS data, the global credit impulse is on the verge of deteriorating, even outside of China. The G10 plus China annual credit impulse is elevated and peaking (Chart 13, left). Meanwhile, quarterly credit impulses in the US, the Euro Area, and China are negative (Chart 13, right), which often leads to turning points in the annual change in credit flows. Chart 13A Global Credit Impulse Problem A Global Credit Impulse Problem (I) A Global Credit Impulse Problem (I) Chart 13A Global Credit Impulse Problem A Global Credit Impulse Problem (I) A Global Credit Impulse Problem (I) A deterioration in the credit impulse could result in a sharp slowdown in global economic growth, because the deceleration in credit creation is broad-based among the major economies. If global growth decelerates, then European economic activity will also suffer. Table 1Essential Sector Breakdowns Risks Risks The impact on European financial markets will come from lower yields. A growth deceleration prompted by a falling credit impulse will put downward pressure on yields and will hurt the performance of value stocks relative to growth equities. Cyclical equities will also underperform defensive ones. In this scenario, European stocks will lag behind their US counterparts because of their relative sectoral biases (Table 1). Within the European benchmark, Tech-heavy Dutch stocks would perform best once yields begin to decline. The effect on growth of the slowing credit impulse remains a risk and not a base case scenario. Last year’s surge in credit intake mostly reflected precautionary demand. Companies around the world tapped their credit lines or the capital markets early in the crisis to build liquidity buffers. They then continued to borrow to take advantage of the exceptionally low interest rates that prevailed throughout most of the year. Similarly, a large proportion of household borrowing amounted to debt refinancing. As a result, last year’s explosion in credit growth had a limited impact on spending. Thus, the credit impulse’s decline in advanced economies should minimally hurt aggregate demand in the coming months. Investment Implication Investors can protect against this risk by overweighting Italian and Spanish bonds in a balanced portfolio. First, these instruments continue to offer better value than other government bonds around the world. Moreover, if global growth turns out to be weaker than expected, the ECB might have to increase the envelope of the PEPP program, which has greatly benefited peripheral bonds. Moreover, the NGEU and REACT EU program buttress weaker European sovereign borrowers. Therefore, yield-hungry global investors will resume their aggressive purchase of the high-yielding peripheral bonds if global interest rates decline anew because of softening economic activity. Risk #3: Stronger Than Expected US Inflation BCA’s house view is that the current surge in global and US inflation is transitory, even if the pressures could last a few months before ebbing. It is mainly a consequence of inadequate aggregate supply in the face of a sudden surge in demand. We cannot be dogmatic about the inflation risk. The price-components of all the major activity surveys in the world are rising, and, in the US, the inflation expectations of households have risen meaningfully (Chart 14). If an inflation mentality were to take root, then core CPI would not decelerate toward yearend. Stronger-than-expected US core CPI would put significant upward pressure on Treasury yields. First, long-dated inflation expectations could begin to converge to the breakeven rates in the shorter tenors of the curve (Chart 15). More importantly, the Fed would become more hawkish sooner. This faster policy tightening would lift the OIS curve and result in higher real yields as well. Chart 14Are Inflation Expectations Becoming Unmoored? Are Inflation Expectations Becoming Unmoored? Are Inflation Expectations Becoming Unmoored? Chart 15Long-Dated Market-Based Inflation Expectations Still Lag Long-Dated Market-Based Inflation Expectations Still Lag Long-Dated Market-Based Inflation Expectations Still Lag The euro would therefore weaken, and the dollar would rally across the board. European inflationary pressures are limited compared to those of the US. The Eurozone suffers from a larger output gap due to the lagging nature of the European recovery, which more timid fiscal stimulus and Europe’s late start to the vaccination campaign compounded. Consequently, the ECB will not match the Fed’s faster tightening of policy, even in this scenario. Higher US TIPS yields and a stronger dollar would ultimately be deflationary blows to global growth. The dollar would directly tighten EM financial conditions. Higher real yields would destabilize stretched equity prices around the world. The resulting shock to global financial conditions would cause a major slowdown in global growth to occur much earlier than we currently foresee. While yields would rise at first, they would end 2022 at much lower levels than we currently expect because of this deflationary outcome. This combination would be very harmful to European equities, both in absolute terms and relative to the global benchmark. At first, European stocks would probably briefly fare well. Once investors begin to digest the deleterious impact of stronger inflation on global growth, however, the pro-cyclical European market will begin to suffer. Tighter EM financial conditions and underperforming financials will only accentuate the European stock market ills. Much stronger inflation is a risk and not a base case for now, because the current bout of inflation is transitory. The supply-side of the economy is already responding to the signal created by higher prices. Firms are set to increase their inventories and capex intentions are moving higher. Moreover, many of the bottlenecks constraining global supply chains will loosen, as the global economy re-opens in response to the international vaccination campaign. Additionally, current labor shortages in low-wage industry will also dissipate, once the $300 weekly support by the US government ends after the month of September. Thus, the supply of labor will also pick up in the fourth quarter of 2021. Moreover, the Fed could remain tolerant of an inflation overshoot, which would limit the pain of its impact. That being said, there is a real inflation risk due to the global deterioration in the dependency ratio and the shift to the left in terms of the economic preferences of the median voter. However, this danger is backdated to 2024 and beyond, once global labor markets are closer to full employment. Investment Implication There is little protection in our current set of recommendations against this risk, but this is a smaller threat than the previous two risks. However, when viewed alongside the first and second set of risks, the combined probability of a dangerous outcome for the market in general and for Europe in particular has grown compared to six months ago. Thus, while the jury is still out on these questions, it makes sense to de-risk portfolios temporarily, until the reward-to-risk ratio has once again improved. Hence, a tactical neutral stance on cyclical relative to defensive equities and on Europe relative to the rest of the world is appropriate for now. Will The ECB Join The BoC? At its April meeting, the Bank of Canada jolted the market by announcing a much earlier-than-anticipated start to its tapering program. We do not believe that the ECB will follow up at its June meeting. In a recent report, BCA’s Global Fixed-Income Strategy team highlighted the constraint that will prevent the ECB from adjusting policy next month.  The main factors are as follows: The results from the ECB’s strategic review have yet to be announced. Adjusting policy before an eventual change in the inflation mandate of the central banks creates an unnecessary risk of policy whipsaw. Yet another policy flip-flop would further mar the ECB’s credibility. Chart 16The ECB Does Not Want To Upend Credit Growth The ECB Does Not Want To Upend Credit Growth The ECB Does Not Want To Upend Credit Growth Loan growth in Europe is slowing down, led by France. However, Italian credit activity is improving in response to the generous TLTRO uptake in the southern economy (Chart 16). At this juncture, a rapid policy adjustment would threaten the recovery, while Europe has yet to re-open. Italian spreads remain fragile. The ECB’s asset purchases are an important contributor to the easing in financial conditions across the periphery. The recent 25bps widening in the BTP-Bund spread is a reminder that European fixed-income markets are not fully tension-free. Thus, a rapid removal of support could prompt a reflex selloff in Italian bonds. The subsequent tightening in financial conditions would unnecessarily feed deflationary pressures in Europe. The euro is strong. If the ECB unsettled the market and removed monetary accommodation as fast or even faster than the Fed, the euro’s rally would suddenly accelerate. This would generate a powerful deflationary shock for Europe that would force the ECB to adjust its inflation forecasts downward. Chart 17Especially When China Creates A Threat Especially When China Creates A Threat Especially When China Creates A Threat The Chinese economy is weak, which increases uncertainty around European economic outcome via the trade channel (Chart 17). Instead, the meetings in the back half of the year are much more likely candidates for the ECB to begin talking about its tapering program. By then, the European economic re-opening will have taken place, to which growth will have responded. The results of the ECB’s strategic reviews will have been announced. Finally, plans will have been ratified for the usage of NGEU funds across the EU, and thus, fiscal clarity will improve. Even if the ECB starts talking before yearend of terminating the PEPP, its communications will indicate that the program’s full envelope will be deployed within the original time frame. Thus, the PEPP program will be in place until the end of March 2022. Moreover, to prevent a rapid deterioration in bank credit, the ECB will continue to provide generous financing to deposit-taking institutions via the TLTRO program. Under these circumstances, the ECB is unlikely to increase its deposit rate before 2014. These views imply that the ECB policy tightening (both on the balance sheet and interest rate fronts) will lag behind that of the Fed, the BoE, the Norges Bank, and the Riksbank. Only the BoJ and the SNB will move after the ECB. The continued involvement of the ECB in the European fixed-income market, along with the elevated likelihood that we remain years away from the first rate hike, confirms that an overweight stance in European peripheral bonds is appropriate. We also continue to overweight corporate credit within European fixed-income portfolios. Our fixed-income colleagues also share these views. Chart 18Justifying A Box Trade Justifying A Box Trade Justifying A Box Trade Finally, the German yield curve should steepen compared to that of the US. Even if the ECB lags well behind the Fed when it comes to tightening policy, the current terminal rate proxy embedded in the EONIA curve is too low (Chart 18). Meanwhile, the earlier lift-off date for interest rates in the US relative to the Euro Area points to rising short rates west of the Atlantic. In this context, a box trade buying steepeners in Europe and flatteners in the US is appropriate, especially since it generates a positive carry of 167 bps (hedged into USD).   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Currency Performance Risks Risks Fixed Income Performance Government Bonds Risks Risks Corporate Bonds Risks Risks Equity Performance Major Stock Indices Risks Risks Geographic Performance Risks Risks Sector Performance Risks Risks Closed Trades

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong China Refinery Runs Remain Strong China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Markets Remained Balanced Markets Remained Balanced Chart 7Inventories Continue To Draw Inventories Continue To Draw Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 RBOB Gasoline at a High RBOB Gasoline at a High Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering European Growth Is Recovering European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Inoculation Acceleration In Europe Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Warning Signs For European Export Demand Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Chart 10NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms ECB Easing Takes Many Forms ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary European Bond Strategy Summary European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 19 at 10:00 AM EDT, 3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT). 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

Highlights US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from stimulus fades and the vaccination campaign winds down. Historically, a slowdown in US growth, as proxied by a decline in the ISM manufacturing index, has been associated with lower overall equity returns, the outperformance of defensive stocks over cyclicals, large caps over small caps, and US equities over their overseas peers. A falling ISM has also been associated with a strengthening dollar, lower Treasury yields, wider credit spreads, a decline in the US Treasury/German bund spreads, falling oil prices, and an increase in the gold-to-copper price ratio. Compared to past episodes, there are three reasons to expect the coming US slowdown to be relatively benign: First, growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still speeding up; and third, monetary policy will remain highly accommodative in the face of what is likely to be a transitory increase in inflation. We continue to maintain a positive 12-month view on global equities. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Crypto update: We warned that “Bitcoin is on a collision course with ESG” two weeks ago. Elon Musk’s flip-flop on allowing customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. With that in mind, we are going short Bitcoin. Beware The Second Derivative US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from fiscal stimulus fades and the vaccination campaign winds down. According to the Brookings Institution, fiscal easing contributed nearly seven percentage points to US growth in the first quarter (Chart 1). However, fiscal policy is set to detract from growth in the remainder of the year, reflecting the one-off nature of some of the stimulus measures. Chart 1After A Strong Boost, Fiscal Thrust Is Turning Negative Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation On the pandemic front, the number of new cases continues to trend lower in the US, thanks mainly to a successful vaccination campaign. A falling infection rate has allowed states to dismantle lockdown measures. Conceptually, it is the change in social distancing measures that correlates with economic growth. While some restrictions remain in place (especially in the educational sector), we are now well past the point of maximum loosening. How have financial markets performed during episodes of slowing US economic growth? To answer this question, we looked at the performance of various assets during periods when the ISM manufacturing index was falling and when it was rising. To add a bit more granularity to the analysis, we also looked at cases when the ISM was trending up and above 50, trending down and above 50, trending down and below 50, and trending up and below 50. As summarized in Table 1 and the Appendix Charts, the key results are as follows: Stocks tend to do best when the ISM is rising. Since 1950, the S&P 500 has risen on average by 1.51% during months when the ISM was trending higher, compared to 0.49% during months when the ISM was trending lower. The results were virtually the same if one restricts the sample to the post-1995 period. While the change in the ISM generally matters more for the S&P 500, absolute levels matter too. Since 1995, the best period for the S&P 500 was when the ISM was below 50 but trending higher (S&P 500 up 2.07%), while the worst period was when the ISM was below 50 and trending lower (S&P 500 up 0.03%). This suggests that swings in the ISM have a bigger effect on the stock market during periods of economic contraction. During periods where the ISM was falling but still above 50, the S&P 500 has delivered a positive – though far from stellar – monthly return of 0.69%. US defensively-geared equities outperformed cyclicals when the ISM was trending lower. During periods when the ISM was falling but still above 50, defensives beat cyclicals by 0.45%. Defensives outperformed cyclicals by 0.84% during periods when the ISM was below 50 and trending lower. US small caps underperformed large caps during periods when the ISM was falling. Non-US stocks also underperformed their US counterparts in a falling ISM environment. The relationship between the ISM and value/growth performance is more ambiguous. To the extent that there is one, value generally outperforms growth when the ISM is below 50. Treasury yields tend to increase, while the yield curve tends to steepen, when the ISM is trending higher. Reflecting the higher beta that Treasuries have to the global business cycle, Treasury yields generally rise more than Germany bund yields when the ISM is on the upswing. Corporate credit spreads tend to widen when the ISM is falling. Spreads narrow the most when the ISM is below 50 but rising. As a countercyclical currency, the US dollar tends to weaken when the ISM is rising and strengthen when the ISM is falling. The prices of cyclically-sensitive commodities such as oil and copper normally decline when the ISM is trending lower, although in general, the bulk of the decline in commodity prices usually occurs only when the ISM has dipped below 50. There is not much of a relationship between gold prices and the ISM. Table 1The Economic Cycle And Financial Assets Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Implications For Today Assuming that the ISM has peaked but remains above 50, the analysis above suggests that the S&P 500 will rise modestly over the coming months; US stocks will edge out non-US stocks; defensives will outperform cyclicals; and large caps will perform slightly better than small caps. The analysis also suggests that Treasury yields will move lower; the Treasury-bund spread will narrow; corporate credit spreads will be flat-to-wider; the dollar will strengthen modestly; and commodities will move broadly sideways. Our own 12-month view is more pro-risk than implied by the ISM analysis. There are three reasons for this: First, US growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still accelerating; and third, monetary policy remains highly accommodative. Let’s examine each assumption in turn. Reason #1: US growth is slowing from exceptionally strong levels While payroll growth surprised sharply on the downside in April, we suspect this was mainly due to pandemic-induced distortions to the seasonal adjustment mechanism used by the Bureau of Labor Statistics. Seasonally unadjusted payrolls rose by 1.1 million in April, which is broadly consistent with the strong pace of GDP growth tracking estimates. The Atlanta Fed GDPNow model points to growth of 11% in Q2. Bloomberg consensus estimates have US real GDP rising by 8.1% in the second quarter. Growth will decline to 7% in Q3 and 4.7% in Q4, but still average 4% in 2022 (Table 2). Table 2Growth Is Peaking, But At A Very High Level Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 2Firms Will Need To Rebuild Inventories Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation US households were sitting on $2.2 trillion in excess savings as of the end of April. This is money they would not have had in absence of the pandemic. Slightly less than half of that stockpile can be attributed to transfer payments, mainly in the form of stimulus checks and unemployment benefits. The rest stems from decreased spending during the pandemic. Not all of this money will be spent immediately. However, given the large sums involved – $2.2 trillion is equivalent to 15% of annual personal consumption – even a partial depletion of these excess savings will be enough to power consumption for the foreseeable future. Meanwhile, firms will have to boost production in order to restore depleted inventories. The inventory-to-sales ratio stands at record low levels (Chart 2). The decline in inventories pushed up the ISM new orders-to-inventory ratio in April, even as the overall ISM index slid from 64.7 in March to 60.7. The new orders-to-inventory ratio tends to lead the ISM index, which suggests that any decline in the ISM index over the coming months will be gradual.    An easing of supply-side constraints should also support growth. Even though overall employment was still 5.2% below pre-pandemic levels in April, a record share of small firms surveyed by the NFIB reported difficulty in filling vacant positions (Chart 3). Enhanced unemployment benefits have eroded the incentive to find work. In addition, many schools remain partially shuttered. Chart 4 shows that mothers with young children have seen a much larger decline in labor force participation than other groups. Chart 3Firms Are Struggling To Find Workers Firms Are Struggling To Find Workers Firms Are Struggling To Find Workers Chart 4Mothers With Children Had To Leave The Labor Force Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Enhanced unemployment benefits will expire in September. As schools resume normal operations, more workers will flow back into the labor market. At the same time, some of the bottlenecks currently gripping the global supply chain should abate, allowing for increased output.   Reason #2: Growth in many other parts of the world is still accelerating Chart 5Over 40% Of S&P 500 Revenues Come From Abroad Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 6Euro Area Data Has Surprised On The Upside Euro Area Data Has Surprised On The Upside Euro Area Data Has Surprised On The Upside S&P 500 constituent firms derive 43% of their revenues from abroad (Chart 5). While Bloomberg estimates suggest that US growth will peak in the second quarter, growth in the euro area is not expected to peak until the third quarter. Mathieu Savary, who heads BCA’s European Investment Strategy service, sees upside risks to European growth estimates for the second half of this year. Consistent with Mathieu’s observations, recent economic data has been surprising to the upside in the euro area (Chart 6). Just this week, economic expectations for both Germany and the wider euro area leaped to the highest level in more than 20 years, according to the ZEW economic research institute. Growth in Japan should also pick up in the remainder of the year. Japan’s vaccination campaign has gotten off to a very slow start, with less than 3% of the population being inoculated to date. The government imposed its third state of emergency on April 25 in response to rising viral case counts. It subsequently extended those restrictions on May 11. The authorities intend to vaccinate the country’s 36 million elderly people by July, when the Olympics are set to begin. This should permit some easing in lockdown measures. Investors are worried that the Chinese economy will slow this year. The Chinese PMIs peaked in November 2020, about the same time as the combined credit/fiscal impulse reached an apex (Chart 7). Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to remain at a still-ample 8% of GDP this year, similar to where it was last year. She expects credit growth to slow by 2%-to-3%, converging towards the pace of nominal GDP growth. Keep in mind that China’s credit-to-GDP ratio stands at 270%. Thus, if credit grows in line with nominal GDP growth of about 10%, this would still leave the stock of credit roughly 27% of GDP higher at the end of 2021 compared to the end of 2020. This hardly constitutes “deleveraging”. A resilient Chinese economy should buoy other emerging markets. Progress on the pandemic front should also help. The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population (Chart 8). The shortages of vaccines in emerging markets could turn into a surfeit by the end of this year, something that market participants do not seem to fully appreciate. Chart 7China: Peak Stimulus And Peak Growth China: Peak Stimulus And Peak Growth China: Peak Stimulus And Peak Growth The rotation in growth momentum from the US to the rest of the world should put downward pressure on the US dollar. A weaker dollar, in turn, has usually coincided with the outperformance of non-US stock markets (Chart 9). Chart 8Vaccine Production Set To Ramp Up Further Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Chart 9A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets   Reason #3: Monetary policy remains highly accommodative The slowdown in US growth is coming at a time when inflation is rising. The core CPI increased by 0.9% month-over-month in April. This was the biggest monthly jump since August 1981. The year-over-year rate climbed to 3.0%, the highest in 25 years. The “whiff of stagflation” helped push the S&P 500 down this week. As we discussed last week, we are very much in the camp that expects inflation to rise significantly over the long haul. Over the next one or two years, however, we would fade inflationary fears. As the example of the 1960s illustrates, a long period of overheating is often necessary to push up inflation in a sustained manner. The US unemployment rate reached its full employment level in 1962. However, it was not until 1966 – when the unemployment rate was two full percentage points below equilibrium – that inflation finally took off (Chart 10). The official core CPI likely overstates underlying inflationary pressures. The pandemic threw all sorts of prices out of whack. Stripping out volatile food and energy prices from inflation is not enough. One needs more refined measures of inflation. Luckily, they exist. Chart 11 shows that median CPI, trimmed-mean CPI, and sticky price CPI all remain well contained. Similarly, relatively clean measures of wage growth, such as the Atlanta Fed Wage Tracker, do not point to an imminent wage-price spiral (Chart 12). Chart 10Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 11Cleaner Measures Of Inflation Are Telling A Different Story Cleaner Measures Of Inflation Are Telling A Different Story Cleaner Measures Of Inflation Are Telling A Different Story Chart 12Wage Growth Is Still Lackluster Wage Growth Is Still Lackluster Wage Growth Is Still Lackluster All this means that the Fed can afford to sustain exceptionally easy monetary policy. That should keep growth at an above-trend pace and continue to support to equity valuations.   Investment Conclusions My “golden rule” for investing is to stay bullish on stocks unless one thinks there is a recession around the corner (Chart 13). Seeing around the corner is not easy, of course, but it is not impossible either. Chart 13Recessions And Bear Markets Tend To Overlap Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Last year’s recession was caused by a true exogenous shock – the pandemic. Most recessions are endogenous in nature, however. They result from growing imbalances that are usually laid bare by tighter monetary policy. One can debate the extent to which the global economy is plagued by imbalances of one form or another. But one thing is clear, monetary policy is unlikely to turn contractionary any time soon. In this environment, one should remain positive on equities and other risk assets over a 12-month horizon. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Go Short Bitcoin We warned that “Bitcoin is on a collision course with ESG” two weeks ago in a report entitled “How To Short Bitcoin, Or Anything Else, Without Losing Your Shorts.” Elon Musk’s flip-flop on allowing Tesla customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. News that Colonial Pipeline paid hackers 75 bitcoin (nearly $5 million) in ransom further cements Bitcoin’s status as the currency of choice for criminals around the world. With all that in mind, we are going short Bitcoin as of midnight Eastern Daylight Time (EDT) using the shorting technique described in that report. The technique flips the usual risk-reward from shorting on its head. Normally, when you short a stock, your gain is capped at 100% of the initial position whereas your potential loss is unlimited. With our shorting technique, your potential loss is capped at 100% while your potential gain is unlimited. This makes shorting as an investment strategy a lot safer. APPENDIX The Economic Cycle And Financial Assets APPENDIX CHART 1A Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation APPENDIX CHART 1B Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Appendix Chart 1C Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Appendix Chart 1D Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Special Trade Recommendations Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation Current MacroQuant Model Scores   Peak Growth And A Whiff Of Stagflation Peak Growth And A Whiff Of Stagflation

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Inflation Rears Its Head Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Equity Market Trembles Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save China's Rising Propensity To Save China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … China's Fiscal-And-Credit Impulse Falls Sharply... China's Fiscal-And-Credit Impulse Falls Sharply... Chart 6B… As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks China Reflation Trades Near Peaks China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus China Verges On Overtightening China Verges On Overtightening Chart 9Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China Verges On Overtightening China Verges On Overtightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China China Verges On Overtightening China Verges On Overtightening Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s China Verges On Overtightening China Verges On Overtightening The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal China Verges On Overtightening China Verges On Overtightening Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 China Verges On Overtightening China Verges On Overtightening The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Stick To Long India / Short China Stick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Feature Chinese stocks remain in limbo despite robust economic data in April and early May (Chart 1).  Onshore equities are pricing in policy tightening risks and a peak in the domestic economic cycle. Meanwhile, a regulatory clampdown on the tech sector continues to curb global investors’ enthusiasm towards Chinese investable stocks.  The PBoC has not changed its course of policy normalization. The falling 3-month SHIBOR since March likely reflects softening demand for interbank liquidity rather than monetary easing (Chart 2). Chart 1Stay Underweight Chinese Stocks Stay Underweight Chinese Stocks Stay Underweight Chinese Stocks Chart 2No Easing In Monetary Policy No Easing In Monetary Policy No Easing In Monetary Policy Fiscal policy has also been consolidating with a renewed focus on reducing local government debt load and financial risks. A delay in local government bond issuance in Q1 could potentially boost bond sales in the second half of the year. However, as we noted late last month, without a synchronized policy push for more bank loans and loosened regulations on provincial government spending, an increase in special-purpose bond issuance alone will not make a significant difference in infrastructure investment nor economic growth. We still expect China's economy, which lags the credit cycle by six to nine months, to start weakening by mid-2021 (Chart 3A & 3B). Chart 3ADomestic Economic Growth Set To Slow Domestic Economic Growth Set To Slow Domestic Economic Growth Set To Slow Chart 3BPolicy Tightening Will Weigh On Earnings Growth In 2H21 Policy Tightening Will Weigh On Earnings Growth In 2H21 Policy Tightening Will Weigh On Earnings Growth In 2H21   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Our BCA Li Keqiang Leading Indicator continues to fall despite a marginal improvement in the Monetary Conditions Index (MCI) component. The deceleration in both money supply and credit growth has more than offset a small uptick in the MCI (Chart 4). Furthermore, a rising RMB in trade-weighted and real terms will not help the profit outlook for China’s exporters (Chart 5). Overall, monetary conditions remain unfavorable for risk assets. This is consistent with the poor performance of Chinese stocks Chart 4Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Falling Credit And Money Growth More Than Offset A Minor Improvement In The MCI Chart 5Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters Strengthening RMB Will Not Help The Profit Outlook For Chinese Exporters   A sharp jump in state-owned enterprise (SOE) defaults since late last year is due to deteriorating corporate balance sheets. The defaults have exposed the weakened fiscal positions of local governments (Chart 6 & 7). SOE bond defaults have surpassed the number of private bond defaults this year. The more restrictive policy on local government financing, together with an acceleration in SOE defaults, will weigh on spending by local governments, local government financing vehicles (LGFVs) and SOEs.  Chart 6Returns On SOE Assets Remain In Deep Contraction Returns On SOE Assets Remain In Deep Contraction Returns On SOE Assets Remain In Deep Contraction Chart 7SOE Bond Defaults Have Surpassed Private Bond Defaults China Macro And Market Review China Macro And Market Review The Politburo meeting on April 30 established new guidelines to reduce local government leverage, both on- and off-balance sheet debt. According to the new rules, local governments are strictly prohibited from obtaining “hidden debts” for new investment projects directly or through their affiliated SOEs, which include LGFVs. The directives also state that the assets of LGFVs with defaulted loans should be restructured or liquidated if companies are unable to repay their debts. In addition, financial institutions should not accept government guarantees when making decisions on lending to LGFVs or government related entities.  Moreover, stricter measures in the property market have further dampened local governments’ fiscal situations since land sales account for 53% of local government fiscal revenues. Growth in government expenditures decelerated in recent months along with slowing land auctions (Chart 8). Scaled down fiscal supports will lead to subdued infrastructure investment growth this year (Chart 9). Chart 8Fiscal Stance Has Tightened Fiscal Stance Has Tightened Fiscal Stance Has Tightened Chart 9Subdued Growth In Infrastructure Investments Subdued Growth In Infrastructure Investments Subdued Growth In Infrastructure Investments   In addition to policy tightening in the domestic economy, Chinese offshore stocks continue to face regulatory headwinds to root out monopolies in technology, media, and telecom (TMT) companies. The antitrust investigations and fines extending from Alibaba and Tencent to Meituan highlight China’s aim to curb platform oligopolies and monopolies. Meanwhile, Chinese tech firms listed on US exchanges are facing another regulatory threat on their accounting reporting standards, which could potentially result in their delisting from the US bourses.  Moreover, elevated valuations and a weakening in the earnings outlook will generate more downside risks for TMT stocks (Chart 10). Given that TMT stocks account for around 50% of the MSCI China Index’s market capitalization, Chinese investable stocks are disproportionally vulnerable to a selloff in TMT stocks (Chart 11). Chart 10ATMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind Chart 10BTMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind TMT Stocks: From Tailwind To Headwind Chart 11MSCI China Is Highly Concentrated In TMT Stocks MSCI China Is Highly Concentrated In TMT Stocks MSCI China Is Highly Concentrated In TMT Stocks   China’s official PMI and the Caixin China PMI moved in opposite directions in April due to the nature of the two surveys. The Caixin PMI covers smaller, more export-oriented businesses while the NBS Manufacturing PMI includes larger, more domestically exposed companies. The divergence highlights that the domestic economy is losing speed while external demand remains robust (Chart 12). Given the dominance of domestic demand in China’s economy (investment expenditures, household spending and government spending), strong external demand will not fully offset the deceleration in domestic growth.  New orders and production subcomponents in the official PMI moderated in April from March, which indicates a slowing momentum in economic activity (Chart 13). Moreover, construction PMI fell to 57.4 from 62.3 in March, corresponding with weaker infrastructure spending and more policy tightening in the real estate sector (Chart 13, bottom panel). Chart 12Conflicting Messages From The NBS And Caixin PMIs Conflicting Messages From The NBS And Caixin PMIs Conflicting Messages From The NBS And Caixin PMIs Chart 13Slowing Momentum In China's Economic Activity Slowing Momentum In China's Economic Activity Slowing Momentum In China's Economic Activity   The moderating momentum in China’s economy is also reflected in April’s trade data, which showed a strengthening external sector and a slowing domestic demand. A few observations support our view: First, strong imports since early this year were partly due to robust re-exports. Solid external demand boosted processing imports, which in turn contributed to China’s overall import growth (Chart 14). Secondly, Chinese imports of commodities in volume, such as copper and steel products, have plunged recently. Chinese domestic demand for commodities will likely peak in the coming months, therefore, inventory destocking pressures and weakness in underlying consumption will threaten commodities prices (Chart 15). Finally, the strengthening of coal imports in volume terms may be related to China’s increasingly stringent environmental policies. A temporary cutback in domestic coal supply boosted the demand for imports. However, in the long run, China’s push for green energy will be bearish for Chinese coal imports (Chart 16). Chart 14Solid External Demand Boosted Processing Imports Solid External Demand Boosted Processing Imports Solid External Demand Boosted Processing Imports Chart 15Demand Of Commodities May Be Approaching A Cyclical Peak Demand Of Commodities May Be Approaching A Cyclical Peak Demand Of Commodities May Be Approaching A Cyclical Peak Chart 16China's Coal Imports Likely To Decline In The Long Run China's Coal Imports Likely To Decline In The Long Run China's Coal Imports Likely To Decline In The Long Run   Housing prices in tier-one cities continue to post major gains despite a slew of tightening regulations in the property sector introduced since the second half of last year (Chart 17). The Politburo meeting last month reiterated authorities’ concerns over a bubble in housing. We expect authorities to impose additional regulations to constrain both financing supply and demand in the property sector. In the meantime, the existing policies have successfully started to cool the real estate market.  Chart 17Skyrocketing Housing Prices In First-Tier Cities Skyrocketing Housing Prices In First-Tier Cities Skyrocketing Housing Prices In First-Tier Cities Chart 18Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Real Estate And Mortgage Loans Tumbled Under More Restrictive Borrowing Regulations Both mortgage loans and loans to real estate developers tumbled under more restrictive borrowing policies (Chart 18). Growth in home sales has also started to roll over (Chart 19). Housing completed has dropped significantly, which confirms that construction activity is decelerating. Looking forward, the reduced expansion rate of new projects due to shrinking land transfers and stricter borrowing regulations will further dampen construction activities in the second half of this year (Chart 20).   Chart 19Home Sales Growth Started To Ease Home Sales Growth Started To Ease Home Sales Growth Started To Ease Chart 20Real Estate Investments Are Set To Slow Further Real Estate Investments Are Set To Slow Further Real Estate Investments Are Set To Slow Further Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review ​​​​​​​   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Tapering: The Bank of England has joined the Bank of Canada as central banks tapering the pace of bond buying. Markets are now trying to sort out who is next and concluding that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. US Treasury Curve: We are adding a new recommended US butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell using US Treasury futures. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime. Feature Heading into 2021, one of our key investment themes for the year was that no major central bank would shift to a less dovish monetary policy stance before the Fed. Not even five months into the year, our theme has already been proven incorrect. Last week, the Bank of England (BoE) announced a slower pace of its asset purchases, following a similar tapering decision by the Bank of Canada (BoC) last month. Chart of the WeekUS Jobs Recovery Lagging, Despite Vaccine Success Who Tapers Next? Who Tapers Next? We had assumed that no central bank could tolerate the currency strength that would inevitably occur by tapering ahead of the Fed. That was clearly not the case in Canada, and the Canadian dollar has already appreciated 4.6% versus the greenback since the BoC taper announcement April 21. The British pound also rallied solidly against both the US dollar and euro immediately after the BoE taper announcement last week. Markets are beginning to speculate on future taper candidates, like the Reserve Bank of New Zealand (RBNZ), with the New Zealand dollar being one of the strongest currencies in the G10 versus the US dollar since the end of March (+4.4%). Investors had been debating the possibility that the Fed could begin tapering sometime in the second half of 2020, largely based on what has to date been a successful US vaccination campaign. Yet while that led to optimism that the US economy can quickly reopen and return to normal, the fact remains that the recovery in US employment from the COVID shock has lagged other major economies (Chart of the Week). The big downside miss on the April US payrolls report highlights how the Fed can be patient before joining the tapering club. US Treasury yields are likely to continue trading sideways, and the US dollar will trade soft, until markets can sort out the true state of US labor demand versus supply. Which Central Bank Could Follow The BoC And BoE? Back in March, we published a report that discussed what we called the “pecking order of global liftoff”.1 We looked at how interest rate markets were pricing in an increasingly diverse path out of the coordinated global monetary easing enacted last year during the COVID recession (Chart 2). We looked at both the timing of “liftoff” (the first rate hike) and the pace of hikes afterward to the end of 2024. We then ranked the countries by the market-implied timing of liftoff. Chart 2Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs At the time, overnight index swap (OIS) curves were discounting the earliest liftoff from the RBNZ (June 2022) and BoC (August 2022). The Fed was expected to hike in January 2023, followed by the BoE in June 2023 and Reserve Bank of Australia (RBA) in July 2023. The European Central Bank (ECB) and Bank of Japan (BoJ) were the laggards, with no rate hiked discounted until September 2023 and February 2025, respectively. In terms of the pace of rate hikes after liftoff through 2024, our list was broken into two groups. The more aggressive central banks were expected to be the BoC (+175bps), RBA (+156bps), RBNZ (+140bps) and the Fed (+139bps). Much smaller amounts of rate hikes were anticipated from the BoE (+63bps), ECB (+25bps) and BoJ (+9bps). In the two months since our March report, the market timing of liftoff, and the pace of subsequent hikes, has shifted for all those countries (Table 1). The BoC is now expected to move in September 2022, ahead of the RBNZ (October 2022). In 2023, the Fed is now priced for liftoff in March 2023, followed by the BoE and RBA (both in July 2023). The ECB liftoff date is little changed (now August 2023), while the market has dramatically pushed out the timing of any BoJ hike (now November 2025). The cumulative rate hikes through 2024 are moderately lower for all countries except Australia (a reduction in total tightening of 56bps). Table 1The Fed Is Sliding Down The “Pecking Order Of Liftoff” List Who Tapers Next? Who Tapers Next? What is interesting about these changes is that the market has pulled forward the timing of liftoff for the BoE and RBA, while pushing it out for the BoC, RBNZ, BoJ and, most importantly, the Fed. The Fed is now drifting down the “pecking order” for liftoff, expected to lift rates only a couple of months before the BoE or RBA. This is a major change from previous monetary policy cycles, when the Fed would typically be a first mover when it comes to tightening policy. Chart 3The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing While the BoC and BoE decisions to taper quantitative easing (QE) have garnered the headlines, the pace of global central bank balance sheet expansion had already peaked at the start of 2021 (Chart 3). The pace has slowed most dramatically in Canada and the US, but this was a result of certain emergency programs expiring – most notably the Fed’s corporate bond buying vehicles late last year and the BoC’s short-term repo facilities more recently. Greater financial market stability was the reason cited to end those programs, while still leaving government bond QE buying in place unchanged. The year-over-year pace of global QE was set to slow, simply from less favorable comparisons to 2020 after the surge in central bank balance sheet expansion last year. Yet now we are starting to see actual tapering of government bond purchases from some central banks. Is such “early tightening” warranted? Back in that same March report where we discussed the order of global liftoff, we gave our assessment of the most important factors that could drive central banks to consider a shift to a less dovish stance (like tapering). For the BoC, we cited booming house prices and robust business confidence as reasons the BoC could turn less dovish sooner (Chart 4). For the BoE, we noted a sharper-than-expected recovery in domestic investment and consumer spending, as the locked-down UK economy reopens, as reasons why the BoE could begin to tweak its policy settings. For both central banks, all those indicators were mentioned as factors leading to their decision to taper. For the Fed, we determined that rising inflation expectations and increasing labor market tightness would both be required for the Fed to turn less dovish. Only inflation expectations have reached that goal, with the US Employment/Population ratio still well below the pre-pandemic peak (Chart 5). For the RBA, we looked solely at realized inflation measures, as the RBA has explicitly noted that Australian wage growth must rise sustainably towards 3% - nearly double current levels - before realized CPI inflation could return to the 2-3% target range. For both the Fed and RBA, the necessary conditions for a change in current policy settings have not yet been met. Chart 4What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching Chart 5What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching For the ECB, we noted that realized inflation (and the ECB’s inflation forecasts), along with the Italy-Germany government bond spread as a measure of financial conditions, were the most important indicators to watch before the ECB could consider any move to taper its QE programs (Chart 6). Italian spreads have widened a bit in recent months, while the latest set of ECB economic forecasts still call for headline euro area inflation to remain well south of the 2% target out to 2023. For the BoJ, we simply cited a rise in realized inflation as the only possible development that could lead to a BoJ taper. The BoJ now forecasts that Japanese inflation will not reach the 2% central bank target until at least 2024. So for both the ECB and BoJ, the conditions do not warrant any imminent tapering of bond buying. Chart 6What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching As another way to determine who could taper next, we turn to our Central Bank Monitors, which are designed to measure the pressure on policymakers to ease or tighten monetary setting. All the Monitors have responded to the recovery in global growth and inflation, along with the easing of financial conditions implied by booming markets, over the past year. Yet only the RBA Monitor is calling for tightening (Chart 7), indicating that the RBA’s current focus on only wages and realized inflation is a departure from their behavior in the past. The Fed and BoE Monitors have risen to the zero line, suggesting no further pressure to ease policy but no tightening is needed either. The ECB, BoJ and RBNZ Monitors are all close, but just below, the zero line, suggesting diminishing need for more monetary stimulus (Chart 8). Chart 7Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Chart 8Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Based on our assessment of the above indicators, we judge the RBNZ to be the next central bank most likely to taper, sometime in the 2nd half of 2021. We still see the Fed starting to signal tapering later this year, but with actual slowing of US Treasury (and Agency MBS) purchases not occurring until early 2022. The year-over-year momentum of bond yields correlates strongly with the Central Bank Monitors. The rise in global bond yields seen over the past year has exceeded the pace implied by the Monitors. This is unsurprising given how rapidly the global economy has recovered from pandemic-fueled recession in 2020. Supply chain disruptions and surging commodity prices have also given a lift to bond yields via rising inflation expectations, even as central banks have promised to keep rates on hold for at least the next couple of years. Yet purely from a monetary policy perspective, the surge in global bond yields looks to have gone a bit too far, too fast. Bottom Line: Markets are now trying to sort out who will taper next after the BoC and BoE, and have concluded that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. Bond yields in other developed markets appear to have overshot economic momentum, and a period of consolidation is needed before yields can begin moving higher again. US Treasury Curve: How Much Steepening Left? Chart 9A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend For most of the past year, the primary trend in the US Treasury curve has been one of bear steepening. Longer maturity yields have borne the brunt of the upward pressure stemming from the rapid recovery in US (and global) economic growth from the depths of the 2020 COVID-19 recession. In recent weeks, however, the surge in longer-maturity Treasury yields has stalled, as have the immediate steepening pressures (Chart 9). Purely from a fundamental economic perspective, a steepening Treasury curve is an expected result of the reflationary mix of growth, inflation and monetary policy currently at work in the US. For example, since the 2020 lows, 5-year/5-year forward inflation expectations from the TIPS market have risen 143bps while the ISM manufacturing index surged from a low of 41 to a high of 65 in March of this year (Chart 10). Combine that with the Fed cutting rates to 0% last year, while promising to keep rates unchanged through 2023 and reinforcing that commitment through QE, and it is no surprise to see a steeper US Treasury curve. Chart 10UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation Yet even despite these obvious steepening pressures, the pace of the Treasury curve steepening does seem to be a bit rapid compared to history. In Chart 11, we show a “cycle-on-cycle” analysis, comparing the slope of various US Treasury curve segments (2-year versus 5-year, 5-year versus 10-year, 10-year versus 30-year) to the average of the previous five US business cycles, dating back to the 1970s. The curves are lined up to the start date of the previous recession, with the vertical line in the chart representing that date. Thus, this chart allows us to see how the Treasury curve evolved heading into, and coming out of, economic downturns. Chart 11 shows that the current 2-year/5-year curve, with a steepness of 63bps, is in line with past steepening moves coming out of recession. For the curve segments at longer maturities, the pace of steepening has been much more rapid than in the past. In fact, the current 5-year/10-year slope of 82bps is already above the average past peak level, as is the 10-year/30-year curve of 72bps. If we do the same cycle-on-cycle analysis for the three previous US recessions dating back to 1990, the current curve slopes are more in line with levels seen one year into the economic expansion (Chart 12). During those previous cycles, the curve steepening trend ended around two years into the expansion. This suggests that the current curve steepening could continue into 2022, except for one major difference – the Fed cut rates to 0% very rapidly last year, far faster than in the previous easing cycles. This suggests that additional curve steepening from current levels can only occur through a surge in US inflation. Chart 11Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Chart 12Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? The slope of the Treasury curve is typically correlated to the level of the nominal fed funds rate, but is even more strongly correlated to the funds rate minus actual inflation, or the real fed funds rate. When the real funds rate is below the natural real rate of interest, a.k.a. r-star, the Treasury curve has historically exhibited its strongest steepening trend. That can be seen in Chart 13, where we show the real fed funds rate (adjusted by US core CPI inflation) compared to the New York Fed’s estimate of r-star. The gap between the two series is shown in the bottom panel, correlating very strongly to the 2-year/30-year Treasury curve slope. Chart 13Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* With the nominal funds rate at zero, that gap between r-star and the real fed funds rate can only widen in a fashion that would support more curve steepening if a) realized US inflation moves higher or b) r-star moves higher. Both outcomes are possible as the US economic recovery, fueled by expanding vaccinations and fiscal stimulus. Both real rates and r-star are much lower in the current cycle than in previous economic recoveries, although the r-star/real funds rate gap appears to be following a more typical path that suggests potential additional steepening pressure (Chart 14). The wild card in this analysis is the Fed itself. If US economic growth and inflation evolve in way that makes it more likely the Fed would have to begin tapering QE and, eventually, signal future rate hikes, the Treasury curve may shift to a more typical bear-flattening trend seen during tightening cycles. We saw an example of that after the release of the March US employment report, where over a million jobs were created in a single month, causing 5-year Treasury yields to jump higher than longer-maturity Treasuries (i.e. curve flattening). Looking ahead, it appears that the US yield curve is more likely to slowly transition to a bear-flattening/bull-steepening regime than continue the bear-steepening/bull-flattening: trend of the past twelve months. One way to position for this is to enter into butterfly curve trades that offer attractive carry or valuation. For that, we turn to our Treasury curve valuation models. We have been recommending a Treasury yield curve trade in our Tactical Overlay portfolio on page 19, going long a 7-year bullet versus going short a 5-year/10-year barbell (Chart 15). This barbell is now very cheap on our models, which measure value by regressing the butterfly spread on the underlying slope of the curve. In this case, the spread between the 5/7/10 butterfly is unusually wide compared to the slope of the 5/10 Treasury curve. According to our model, this butterfly spread discounts nearly 100bps of additional 5/10 steepening, an excessive amount compared to past cycles. Chart 14R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks Chart 15Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade While the valuation is attractive on the 5/7/10 butterfly (Table 2), the carry on this position is a modest 12bps. A butterfly with more attractive carry is the 2/5/30 butterfly. Table 2US Butterfly Strategy Valuation: Standardized Residuals Who Tapers Next? Who Tapers Next? Table 3US Butterfly Strategies: Carry Who Tapers Next? Who Tapers Next? Chart 16Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade This butterfly has a neutral valuation (Chart 16) on our model, but offers 35bps of carry - the most attractive among all butterflies involving a 5-year bullet (Table 3). With US Treasury yields, and the Treasury curve slope, likely to remain rangebound for the next few months, going for higher carry trades is an attractive strategy – particularly if used in conjunction with a below-benchmark duration stance, which we still advocate. The 2/5/30 butterfly represents an attractive near-term hedge to that more defensive duration posture. Bottom Line: We are adding a new recommended US Treasury butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Who Tapers Next? Who Tapers Next? ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Non-US stocks have greatly underperformed US equities over the last decade, but a leadership change might be underway. As such, equity flows could be an important factor in dictating currency trends over a cyclical horizon. The narrative in favor of non-US stocks includes a recovery in profits, cheap valuations, and a secular theme that will favor capital spending in traditionally “heavy” industries. Non-US growth should also overtake the US beyond 2021, when most of the global population is vaccinated. Cyclical currencies have historically tracked the relative performance of their respective bourses. This implies a lower dollar. Higher bond yields also present a formidable headwind for the outperformance of US stocks, relative to other markets. An outperformance of non-US bourses will be particularly favorable for the AUD, NOK, SEK, and GBP. The yen will likely play catchup towards the middle of the cycle. Feature Currencies respond to broad inflows, including into bonds, equities or foreign direct investment. For most of 2020, the dominant currency flows were from fixed income investors. As most short rates are now anchored near zero, the story is morphing towards the potential winners from a recovery, especially in the equity market sphere. Non-US stocks tend to outperform the US when the dollar is falling. That said, the causality-effect link is not so clear-cut, as we penned in our Special Report last year.1 Admittedly, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. Meanwhile, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. Financing costs for non-US corporations borrowing in dollars are also eased. Historically, profit growth has been the ultimate driver of stock prices and profitability is more contingent on productivity gains than translation effects. This suggests the starting point for gauging relative equity flows, and the potential impact on currencies, is to evaluate which countries/economies could be primed for outperformance. Relative Growth As A Starting Point One of the key drivers of relative earnings growth between two countries is relative economic performance. Chart I-1 shows that earnings-per-share in the G10 relative to the US tended to improve when growth was shifting in favor of the rest of the world. This, in turn, has been a key driver of relative equity performance. Chart I-1Relative Profits And Relative Growth Relative Profits And Relative Growth Relative Profits And Relative Growth What is remarkable is that this relationship has been pretty consistent across countries, including those that have huge exposures to the global economy such as Sweden, Norway, or even the United Kingdom. In general, relative economic performance has driven relative EPS growth (Chart I-2A & 2B). The reason is that these bourses still have a sizeable dependence on the domestic economy. Chart I-3 shows that for even the most export-driven economies, exposure to domestic sales is still at least 20%. Australia, a commodity country has almost 60% of sales from domestic sources. Our bias is that non-US growth will start to outperform towards the backend of this year. This will pressure the dollar lower (Chart I-4). This conviction rests on three critical pillars: Chart I-2AA Cross Country Look At Relative Profits Growth A Cross Country Look At Relative Profits Growth A Cross Country Look At Relative Profits Growth Chart I-2BA Cross Country Look At Relative Profits Growth A Cross Country Look At Relative Profits Growth A Cross Country Look At Relative Profits Growth   Chart I-3Domestic Sales Matter A Lot For Global Equity Bourses Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals Chart I-4The Dollar Trends With ##br##Relative Growth The Dollar Trends With Relative Growth The Dollar Trends With Relative Growth   The rest of the world will catch up in vaccination campaigns relative to the US. This is almost a fait accompli. Canada is well behind in terms of vaccination progress compared to the US or the UK (Chart I-5). But in Quebec, where BCA is headquartered, Premier François Legault has suggested that everyone who wants a vaccine will be able to get their first dose by June 24. Relative employment growth in Canada is already picking up, and the central bank has already begun tapering asset purchases ahead of the Fed. The broader message is that the service sector has been held hostage by relatively closed economies outside the US. This will change as economies open up.   Producer prices (PPI) are picking up globally and the US is leading the pack. This will also rotate in favor of other economies. Producer prices first took off in the US as the sectors that benefited from the pandemic were those related to technology and healthcare. Norway also gained from the rebound in oil prices. Other countries should begin to catch up, as demand for goods and services broadens beyond the pandemic-related scope (Chart I-6). From a longer-term perspective, PPI usually peaks and troughs in the US ahead of other economies. Again, as we exit a recession, consumption tends to broaden from defensive goods towards more discretionary spending. Given that other economies are bigger producers of these discretionary items, this should start to shift relative pricing power towards these countries (Chart I-7). Non-US growth has been held hostage to cascading crises since the US housing market bust. In 2010, we had the euro area debt crisis. In 2011, the Fukushima disaster knocked down Japanese growth. In 2015, tight monetary policy in China led to a global manufacturing recession. In short, rest-of-world growth has not been able to catch breath for a decade. Chart I-5Many Countries Will Replicate The US and UK Vaccination Success Many Countries Will Replicate The US and UK Vaccination Success Many Countries Will Replicate The US and UK Vaccination Success Chart I-6Global PPIs Are ##br##Picking Up Global PPIs Are Picking Up Global PPIs Are Picking Up   Chart I-7US PPI Usually Leads Other Countries US PPI Usually Leads Other Countries US PPI Usually Leads Other Countries The silver lining is that the COVID-19 crisis has ushered in coordinated global monetary and fiscal stimulus. For the first time in a long while, non-US growth can start to outperform, according to IMF estimates (Chart I-8). Chart I-8The IMF Expects Non-US Growth To Outperform The IMF Expects Non-US Growth To Outperform The IMF Expects Non-US Growth To Outperform Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when US versus non-US stocks are concerned. If we accept the premise that relative growth matters for equity allocations, then it also makes sense that relative equity performance will coincide with currency performance, due to portfolio flows. Across the G10 economies, getting the equity call right has usually been synonymous with having the appropriate currency strategy (Chart I-9). This is especially the case since equity flows have been supportive of the dollar (Chart I-10). Chart I-9ACurrencies And Equities Move Together Currencies And Equities Move Together Currencies And Equities Move Together Chart I-9BCurrencies And Equities Move Together Currencies And Equities Move Together Currencies And Equities Move Together Chart I-10Equity Flows Have Been Supportive Of The Dollar Equity Flows Have Been Supportive Of The Dollar Equity Flows Have Been Supportive Of The Dollar A More Quantitative Approach While relative growth is important, it is not the sole factor in determining which countries or sectors will outperform. Most investors have at least two other powerful tools that have stood the test of time in making equity allocations. These include the valuation starting point, and the historical return on capital. Valuation is the easiest place to start. Over time, non-US bourses have tended to outperform the US when the relative valuation starting point was attractive. This has been especially true around recessions, when leadership changes tend to occur. Chart I-11A, 11B, 11C, and 11D show that countries such as Japan, Mexico, and Germany should sport more attractive returns over the next decade compared to the US. The list is not comprehensive, but our previous work suggests this valuation tool works across many countries and various geographies. Chart I-11AValuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Chart I-11BValuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Chart I-11CValuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Chart I-11DValuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Valuation Matters For Long-Term Returns Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals   Not surprisingly, the currencies that are the most undervalued in our models also have cheap equity markets. These include the Scandinavian currencies, commodity plays, the Japanese yen, and the pound. A rerating of these markets will be synonymous with a rerating in their currencies (Chart I-12). The rise in global bond yields will also prove to be a formidable headwind for US stocks. Technology constitutes 28% of the US equity market, the largest allocation within the G10. Together with defensive sectors such as health care and consumer staples, this ratio rises to 60%. As a result, the relative performance of the US equity market has been inversely correlated to bond yields (Chart I-13). Should bond yields continue to gravitate higher over the next few years, this will lead to a powerful rotation towards more cyclical bourses. The rise in yields will be particularly favorable for deep value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12The Dollar Remains ##br##Expensive Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals Chart I-13US Outperformance Has Dovetailed With Lower Bond Yields US Outperformance Has Dovetailed With Lower Bond Yields US Outperformance Has Dovetailed With Lower Bond Yields Going forward, expected return on capital will be more difficult to gauge, but countries that have a history of providing superior shareholder returns are a good place to start. For example, we know that the winners of the last decade have had the largest returns on equity, as was the case for the winners during the prior decade. Given the mammoth task of performing this exercise on a cross-country basis, and across factors, we enlisted the help of our colleagues who run BCA’s Equity Analyzer platform. The EA platform provides a BCA score of 0 to 100 for all developed market stocks, according to their ranking on 30 carefully selected and curated factors. Crunching the numbers revealed a few interesting results: A long strategy based on selecting the top decile stocks according to their EA score outperformed both domestic and global indices (Chart I-14). The quality factor has been one of the better determinants of future stock market returns. The EA quality score is based on return on equity, asset growth, accruals, and margins. On this basis, the bourses with a higher concentration of quality stocks in their indices are found outside the US (Chart I-15). Using an overall blended score, which includes not only the quality factor, but also others such as value, size, and momentum, suggests investors will be rewarded by tilting away from the US. For example, 20%-30% of stocks in Scandinavian bourses make it into the top decile EA portfolio (Chart I-16). Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive (Chart I-17). Chart I-14The BCA EA Platform Allows Investors To Pick Winners Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals Chart I-15Quality Stocks Are Heavily Weighted Outside The US Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals Chart I-16A Composite Score Ranks US Stocks Poorly Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals Chart I-17Lots Of Attractive Growth Stocks Outside The US Trading Currencies Using Equity Signals Trading Currencies Using Equity Signals In a nutshell, non-US markets are attractive from a valuation standpoint and across a swathe of other metrics that have been useful in benchmarking future returns. An outperformance of non-US stocks will favor cyclical currencies, as portfolio flows gravitate to these markets. We are already selectively long a basket of Scandinavian currencies; we will be gradually accumulating other currencies such as the GBP, the CAD, and the JPY on weakness. Specifically, the yen is becoming interesting not only as portfolio insurance, but also as a play on the cyclical Japanese market. We will be covering these currencies in depth in upcoming reports. Housekeeping Three important central banks met this week. The general tone was dovish. The Bank of England kept policy roughly unchanged, but there were three important takeaways. First, the BoE suggested any pickup in UK inflation will be transitory. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward. Our take is that the meeting was a non-event for cable in the near term and bullish longer term. The message from the Reserve Bank of Australia was bit more dovish. They kept open the possibility of additional measures on the July 6 meeting. Our bias is that the RBA is trying to fend off deflationary pressures from a strong currency. This only delays the bullish backdrop for the AUD. Next Tuesday’s budget will provide some information about additional support to the Aussie economy. The Norges bank remains on the path to hike interest rates later this year. This supports our bullish NOK thesis. We have been reluctant to establish fresh long positions as we enter a seasonally strong month for the dollar. However, our buy list is growing as we highlighted above. For now our open positions are highlighted on page 14.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data out of the US were mildly positive. The ISM Manufacturing PMI came in at 60.7 in April, well below an estimate of 65. The ISM Manufacturing New Orders Index came in at 64.3 in April, slightly below an expectation of 66.6. The trade deficit for March was -74.4B USD, in line with expectations. Personal Spending for March was 4.2% month-on-month, as expected. The dollar DXY index rose by 0.8% this week. While the PMI data for April came in on the mild side, inflationary pressures continue to build up as reflected in the robust New Orders, Backlog of Orders as well as the Prices Paid indices. That said, the Fed’s current stance is that price surges will likely be transitory. This is near-term negative for the greenback since it implies policy will not be tightened anytime soon. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent Euro data have been mildly positive. Unemployment rate for March was 8.1%, slightly better than the predicted 8.3%. GDP fell 1.8% year-on-year, compared to an expected 2% decrease. CPI came in at 1.6% for April year-on-year, in line with expectation. German Retail Sales for March came in at 7.7% month-on-month comfortably beating a 3% expectation. Overall euro area retail sales surged 12% year-on-year in March, comfortably outpacing consensus of a 9.4% rise. The euro was down 0.9% against USD this week. However, as the weekly vaccination increase in both the US and the UK are slowing down, it continues to rise in the euro area.  Infections are stabilizing in Germany and the Netherlands, and are on a downtrend in France and Italy. This puts a floor under the euro. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 The recent data out of Japan have been strong. The unemployment rate for March came in at 2.6%. Industrial Production for March came in at 2.2% month-on-month, versus the estimate of -2%. Tokyo Core CPI came in at -0.2%, below market consensus. Vehicles sales surged by 22.2% year-on-year in April. The Japanese yen was flat against USD this week. A lagging vaccine campaign, rising COVID-19 case count, and the state of emergency continue to drag down sentiment towards Japan. However, the yen’s real effective exchange rate is trading at one standard deviation below fair value and our intermediate-term indicator is hinting at a rebound. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data out of UK have been positive. The Nationwide HPI for April was 7.1% higher than a year ago, beating an expectation of 5%. The BoE kept interest rates at 0.1% and its asset purchase target at £895bn. The pound was flat against the USD this week. The Bank of England kept policy on hold this week, but there were three important takeaways. First, the BoE sees any near-term pickup in inflation as temporary. This should keep a near-term lid on rate hike expectations and the pound. Second, the BoE will slow its bond purchases, as they approach the central bank’s target. And finally, growth estimates were revised upward, especially for 2022. This is bullish cable longer term. On the political front, a potential surprise of another Scottish independence may put some downward pressure on the currency. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The recent data out of Australia have been strong. The AIG Manufacturing Index for April came in at 61.7, higher than the prior 59.9 reading. The AIG Construction Index for April came in at 59.1, below the 61.8 print in March. The trade balance for March came in at AUD 5.6bn, below an expectation of AUD 8bn. The RBA cash rate remained at 0.1%. The Australian dollar was flat this week against the USD. The RBA provided a dovish tone at its meeting this week, extending QE until February, and kept open the possibility of additional measures on the July 6 meeting. In the near term, upbeat economic data continue to provide support for the AUD. However, the tourism industry (6% of employment) is needed to get Australia back to full employment. Our bias is that the RBA will continue to fight against an appreciating currency, until the economy reaches escape velocity. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data out of New Zealand have been strong. Employment grew by 0.6% quarter-on-quarter in Q1. The Labor Cost Index for Q1 came in at 0.4% over prior quarter, and 1.6% year-on-year. The unemployment rate for Q1 declined to 4.7%, from 4.9%. Building consents increased 17.9% month-on-month in March. The New Zealand dollar was down 0.5% against USD this week. As we indicated in our report last week, the NZD is overpriced by several measures and the elevated equity market is of particular concern. The weakening GlobalDairyTrade Price Index could potentially be a harbinger of peaking agricultural prices in the coming months. This will lead the NZD to underperform other commodity currencies.  Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada have been soft. The trade balance for March came in at -1.14bn CAD versus CAD 1.42bn the previous month. Building permits rose 5.7% month-on-month in March. The CAD was flat against USD this week. Despite concerns over elevated commodity prices and a vaccination campaign that is lagging other advanced economies, recent strong employment growth and the tapering of asset purchases by the BoC should continue to boost the currency, the top performing among G10 so far this year. In the near term, Canadian exports will benefit from US fiscal stimulus, which will also provide support for the loonie. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The recent Swiss data have been strong. The KOF Leading Indicator for April came in at 134, beating the 119.5 estimate.  CPI for April came in at 0.3%. SECO Consumer Climate for Q2 came in at -18, higher than the -30 back in Q1. The Swiss franc was down 0.5% against the USD this week. The Swiss economy continues to surprise to the upside. With our intermediate-term indicator on a downward path, we remain optimistic on our long EUR/CHF position for now, despite potential upside risks to the franc given the Indian COVID-19 outbreak. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The recent data out of Norway have been strong. The unemployment rate for April came in at 4%, from 4.2% the prior month. The house price index for April came in at 12.2% year-on-year, similar to the 12.5% reading of March. Interest rate were held at 0% by the Norges Bank. The NOK was down 1.8% against the USD this week. The krone is the winning currency since the pandemic hit, suggesting some consolidation was much due. With Norwegian inflation rising sharply above the central bank’s 2% target earlier this year, the Norges Bank reiterated during its meeting on Thursday that a rate hike later this year is well in sight. Against the backdrop of the impending European recovery this summer and Norway’s own commendable vaccination progress, we continue to be long the NOK against the USD and EUR.  Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The recent Swedish data have been strong. Industrial Production for March came in at 1.1% month-on-month. Year-on-year, IP is rising by 5.7%. Industrial New Orders for March came in at 10% year-on-year. GDP in Q1 was 1.1% higher than the prior quarter, beating the estimate of 0.5%. The Swedish krona was down 1.4% against the USD this week. BCA Research’s European Investment Strategy service indicated that there is significantly more upside to Swedish stocks against both Eurozone and US equities over the remainder of the cycle. Sweden is levered to the global industrial cycle with exports representing 45% of GDP. The recovery in both Europe and across the globe should continue to benefit the krona. The tapering of asset purchases by the Riksbank later this year will also provide support to the currency in the meantime. We continue to be long SEK/USD and SEK/EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The modern-day version of the Phillips curve posits that core inflation is determined by long-term inflation expectations and the amount of slack in the economy. In practice, using the Phillips curve to forecast inflation is complicated by uncertainty over: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. While economists should be humble in forecasting inflation trends, the bulk of the evidence suggests that core inflation will remain subdued for the next two-to-three years. However, when inflation eventually does begin to rise, it could happen faster and more forcefully than expected. For the time being, inertia in inflation expectations will allow the Fed and other central banks to maintain a highly accommodative monetary stance. This will keep a lid on bond yields, while fueling further gains in equity prices. Today’s goldilocks environment will give way to a period of stagflation in the second half of the decade, however.  The Phillips Curve: Flat… For Now It has become fashionable to criticize the Phillips curve. The reason is understandable: Wild swings in the unemployment rate over the past few decades have failed to translate into meaningful changes in inflation. As we argue in this report, however, it is too early to write off the Phillips curve. Perhaps not today, perhaps not tomorrow, but at some point, it will come roaring back. Investors need to be on guard for when it happens. Conceptually, the modern-day version of the Phillips curve posits that core inflation is a function of long-term inflation expectations and the amount of slack in the economy. Mathematically, it can be written as: Dissecting The Phillips Curve Dissecting The Phillips Curve   Where πt is core inflation at time t, πe is expected long-term inflation, y is GDP, ȳ is the potential (or “full employment”) level of GDP, and α is a parameter specifying how sensitive inflation is to changes in the output gap, yt – ȳt. A positive output gap implies that output is above potential while a negative gap implies output is below potential. The equation reveals three sources of uncertainty about inflation: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. Let’s examine all three sources of uncertainty in order to gauge where the balance of risks to inflation lie over the coming months and years.   1. What Is The Current Size Of The Output Gap? Chart 1Prime-Age Employment-To-Population Ratios Remain Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratios Remain Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratios Remain Below Pre-Pandemic Levels The short answer is that no one knows. The employment-to-population ratio in the OECD for workers between the ages of 25-to-54 was still more than two percentage points below pre-pandemic levels as of the end of last year (Chart 1). The labor market has tightened since then, especially in the US. However, even if US payrolls rise by 1 million in April as per Bloomberg consensus estimates, total employment would still be down 4.7% from January 2020. Admittedly, other data point to a much tighter labor market. US small businesses surveyed by the NFIB have been reporting grave difficulty in finding qualified workers (Chart 2). The job openings rate is at an all-time high, while the quits rate is near pre-pandemic levels (Chart 3). Chart 2US: Temporary Labor Shortage (I) US: Temporary Labor Shortage (I) US: Temporary Labor Shortage (I) Chart 3US: Temporary Labor Shortage (II) US: Temporary Labor Shortage (II) US: Temporary Labor Shortage (II)     How does one square widespread stories of labor shortages with the fact that total employment remains depressed? A pessimistic interpretation is that the pandemic pushed up structural unemployment. We are skeptical of this thesis. A similar narrative was invoked shortly after the Great Recession to justify tighter fiscal policy and an early start to rate hikes. In the end, not only did the unemployment rate return to pre-GFC levels, but it dropped to a 50-year low. A more plausible explanation is that many service sector workers are currently reluctant to re-enter the labor market due to lingering fears about the pandemic, and in some cases, the need to remain home to look after young children studying remotely. In addition, generous unemployment benefits – which for more than half of US workers exceed their take-home pay – have reduced the incentive to work. Expanded unemployment benefits will expire in September. As the pandemic winds down and schools fully reopen, more workers will rejoin the labor force. Bottom Line: Temporary dislocations are curbing labor supply. However, the level of employment will probably not return to its pre-pandemic trend for another 12 months in the US. It will take even longer to get back to full employment in the euro area and Japan. 2. How Do Changes In The Output Gap Affect Inflation? The Phillips curve was reasonably steep between the mid-1960s and mid-1980s. As such, a falling output gap generally corresponded to rising inflation and vice versa. The result was a series of “clockwise spirals” in inflation-unemployment space, as illustrated in Charts 4A & 4B. Chart 4AThe Phillips Curve Was Steep In The 1960s-1980s Dissecting The Phillips Curve Dissecting The Phillips Curve Chart 4BThe Phillips Curve Has Been Flat In Recent Decades Dissecting The Phillips Curve Dissecting The Phillips Curve Starting in the 1990s, the Phillips curve flattened out. By the time of the Great Recession, the slope of the curve was indistinguishable from zero. Will the Phillips curve remain flat? Over the next two years, the answer is probably yes. However, looking beyond then, it is likely to re-steepen again. Chart 5 shows that the “wage version” of the Phillips curve never became very flat. Even after the mid-1980s, there was still a consistently strong negative correlation between wage growth and the unemployment rate. Chart 5The Wage Version Of The Phillips Curve Is Alive And Well The Wage Version Of The Phillips Curve Is Alive And Well The Wage Version Of The Phillips Curve Is Alive And Well Chart 6Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s   Why, then, did stronger wage growth fail to translate into rising price inflation over the past three decades? To a large extent, the answer is that the Fed began to hike interest rates every time the labor market showed signs of overheating. Higher rates, in turn, led to asset busts. During the 1991 recession, it was the commercial real estate bust; in 2001, it was the dotcom bust; and in 2008, it was the housing bust. All three asset busts led to recessions and higher unemployment before wage growth could seep into inflation. What is different this time is that the Fed is a lot more patient. This means that the economy may eventually overheat to a degree not seen in recent history. How long will that take? Probably a few more years. Consider the case of the 1960s. The unemployment rate was at or below its full employment level for four straight years before inflation took off in 1966 (Chart 6). The shortage of workers spawned a major wage-price spiral. Workers demanded higher wages in response to rising prices, which forced firms to further lift prices in order to defend profit margins. Chart 7US Wage Barometers Disaggregated US Wage Barometers Disaggregated US Wage Barometers Disaggregated The US is nowhere near that point now. While some measures of wage growth have accelerated, this mainly reflects a “composition bias” in the way wage indices are constructed. The pandemic led to significant job losses in low-wage sectors such as retail and hospitality, which skewed the calculation of average hourly wages and median weekly earnings to the upside. Cleaner measures of wage growth, such as the Employment Cost Index or the Atlanta Fed Wage Tracker, have been fairly stable over the course of the pandemic1 (Chart 7). Bottom Line: There is good reason to think that the Phillips curve is “kinked”, meaning that inflation might not rise much until the labor market has severely overheated. For now, no major economy is near the kink.   3. Will Long-Term Inflation Expectations Stay Well Anchored? One of the distinguishing features of the clockwise spirals in Chart 4 is that they trace out a series of “higher highs” and “higher lows” for inflation during the period between the mid-1960 and early-1980s. In essence, what happened back then was that inflation would rise, prompting the Fed to step on the brakes ever so gingerly. Inflation would then decline modestly, but not by enough to bring it back to its original level. The “stickiness” of inflation during that era highlights the importance of inflation expectations. In the context of the Phillips curve, a change in long-term inflation expectations could, at least theoretically, affect realized inflation independent of what happens to the output gap. In practice, however, the size of the output gap is likely to influence inflation expectations and vice versa. A persistently positive output gap will cause inflation to consistently exceed its long-term expected value. As Milton Friedman and Edmund Phelps pointed out more than four decades ago, this will eventually prompt businesses and the public to revise up their expectations of inflation. Unless the central bank lifts interest rates by enough, a rise in inflation expectations could spur people to increase spending in advance of higher prices. This could cause the economy to further overheat, leading to even higher inflation expectations. In other words, a positive output gap could lead to higher inflation expectations, and higher inflation expectations, in turn, could push aggregate demand even further above potential. Suppose that people jettison the expectation of a stable long-term inflation rate and adopt an “adaptive” approach whereby they assume that inflation this year simply will be what it was last year. This is equivalent to replacing πe in the Phillips curve equation with πt-1, yielding:   Dissecting The Phillips Curve Dissecting The Phillips Curve This is the “accelerationist” version of the Phillips curve. It says that the output gap determines the change in inflation rather than the level of inflation. With an accelerationist Phillips curve, inflation can increase without bound if the central bank tries to keep output above its potential level. The transition to an accelerationist Phillips curve appears to have happened in the 1970s. As my colleague Jonathan Laberge has argued, and as recent empirical work has emphasized, changes in inflation expectations generally have a larger impact on realized inflation than changes in the output gap. In particular, it is difficult to explain the Volcker disinflation solely based on the movement in the unemployment rate. Inflation continued to fall even after the unemployment rate peaked in December 1982. The surprising decline in inflation following the recession even prompted two young economists working at the Council of Economic Advisors, Paul Krugman and Larry Summers, to pen a memo entitled “The Inflation Timebomb?” in which they predicted a “significant reacceleration of inflation in the near future”. Chart 8Long-Term Inflation Expectations Remain Well Anchored Today Long-Term Inflation Expectations Remain Well Anchored Today Long-Term Inflation Expectations Remain Well Anchored Today Why did inflation keep falling in the 1980s as the economy recovered? A plausible theory is that Paul Volcker’s appointment to Fed chair marked a “regime shift” in the conduct of monetary policy. No longer would the Fed stand idly by as inflation galloped higher. Even if it took double digit interest rates and a deep recession, the Fed would do what was needed to break the back of inflation. This allowed the accelerationist Phillips curve of the 1970s to transition to its modern-day version characterized by low and stable inflation expectations. What does all this mean for today? Both survey and market-based measures of long-term inflation expectations remain well anchored (Chart 8). Given that inflation expectations have been low and stable for the past few decades, it may take even more overheating than what occurred in the 1960s to unmoor them. Such an unmooring of inflation expectations is not impossible, however. The Fed seems eager to overheat the economy. Fiscal policy is likely to remain highly accommodative long after the pandemic restrictions ease. Meanwhile, as we discussed in an earlier report, many of the structural factors that have suppressed inflation could go into reverse. Bottom Line: Inflation expectations are likely to remain well anchored for the next two years. However, they could become unmoored later on if monetary and fiscal policy remain highly accommodative. Concluding Thoughts There is a lot of concern over inflation these days. We would fade these concerns, at least for the time being. The much-discussed spike in manufacturing input prices is nothing new. The exact same thing happened in 2008 and 2011 (Chart 9). Pundits who hyperventilated about soaring inflation were proven wrong back then and they are likely to be proven wrong again this year. Chart 9Wholesale Inflation Rose (Briefly) In 2008 And 2011 Too Wholesale Inflation Rose (Briefly) In 2008 And 2011 Too Wholesale Inflation Rose (Briefly) In 2008 And 2011 Too Chart 10The Most Refined Measures Of Core Inflation Paint A Benign Picture The Most Refined Measures Of Core Inflation Paint A Benign Picture The Most Refined Measures Of Core Inflation Paint A Benign Picture   The pandemic distorted prices in all sorts of unprecedented ways. This means that looking at standard measures of core inflation may be misleading. It is much better to consider more refined measures of core inflation that go beyond simply stripping out the effects of volatile food and energy prices. Chart 10 shows that trimmed-mean inflation, median price inflation, and sticky price inflation all suggest that underlying inflation remains well contained. Continued low inflation will allow the Fed to maintain a highly accommodative monetary policy. This will keep a lid on bond yields, while fueling further gains in equity prices. When will it be time to worry? When the labor market starts to overheat to the point that a wage-price spiral erupts. As discussed above, that is not a near-term risk. However, such a spiral could occur in two-to-three years, setting the stage for a period of stagflation in the second half of the decade.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next.   Global Investment Strategy View Matrix Dissecting The Phillips Curve Dissecting The Phillips Curve Special Trade Recommendations Dissecting The Phillips Curve Dissecting The Phillips Curve Current MacroQuant Model Scores Dissecting The Phillips Curve Dissecting The Phillips Curve