Euro Area

Dear Client, The next two BCA Research Global Fixed Income Strategy reports will be jointly published with other BCA services, which will impact the publishing dates. Our next report will be a joint Special Report on Australia, published with our colleagues at Foreign Exchange Strategy, which you will receive this Friday, November 19. The following report will be a joint Special Report published with European Investment Strategy, which you will receive on November 29. -Rob Robis   Highlights High realized inflation rates are pushing up longer-term inflation expectations toward all-time highs, while also weighing on consumer confidence, in the US and the UK. The inflation overshoot has not been as severe in the euro area, but consumer confidence appears to be rolling over there too. Over the next year, central banks will have to manage around the communications challenges posed by a rise in inflation that is perceived to be more supply-driven than demand-driven and, hence, beyond the full control of monetary policy. Public opinion surveys are showing eroding satisfaction with the Fed and Bank of England, while similar surveys in the euro area show public trust in the ECB remains strong despite higher euro area inflation.  We continue to favor overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23, compared to the euro area, in order to restore central bank credibility.  Feature Rapidly accelerating inflation has become front-page news around the world. It is also increasingly becoming a political issue and not just an economic one. After the release of the October US consumer price index (CPI) report, where headline inflation came in at a 30-year high of 6.2%, US President Joe Biden had to issue a formal White House statement acknowledging that inflation “hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” Biden also pulled off the neat trick of both committing to, and subtly challenging, the Fed’s independence when he noted that “I want to reemphasize my commitment to the independence of the Federal Reserve to monitor inflation, and take necessary steps to combat it.” The Great Inflation Of 2021 (and 2022?) has raised a new risk for both politicians and investors. As long as the high inflation persists, and for as long as central banks seem unwilling or unable to respond to try and bring down inflation with tighter monetary policy, consumer confidence will be negatively impacted – even if job growth remains reasonably healthy. Confidence & Inflation: A Matter Of Trust Chart of the WeekHigh Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence The preliminary read on US consumer confidence for November from the University of Michigan survey showed sentiment hitting a ten-year low, largely on worries about the impact of rising inflation on household spending power. This effect of high inflation eroding consumer confidence is not just a US phenomenon (Chart of the Week). UK consumer sentiment is also falling due to what has been described as “a potential cost of living crisis” by consumer research firm GfK. In the euro area, however, consumer sentiment is still relatively elevated, but is starting to roll over as headline inflation reaches a 13-year high of 4.1% in October. From the point of view of financial markets,  surging inflation is still expected to be a short-lived phenomenon, although conviction on that view is starting to wane. Market-based inflation expectations curves for the US, UK and euro area are all currently inverted, with shorter-maturity expectations above longer-maturity ones (Chart 2). Yet the upward momentum of those measures across all maturity points is showing little sign of ebbing, especially in the US. The 2-year TIPS breakeven rate now sits at a 16-year high of 3.51%, the 5-year breakeven is at an all-time high of 3.22%, while the 10-year breakeven of 2.77% is now just a single basis point below its all-time high reached in 2005. The story is similar in the UK, where RPI swap rates for the 2-year, 5-year and 10-year maturities are 5.3%, 4.8% and 4.3%, respectively – all hovering near all-time highs (as are breakevens on index-linked Gilts). Euro area inflation expectations are not so historically elevated, and the inflation curve is not as inverted, but the 2-year euro CPI swap rate is still at a 15-year high of 2.4% compared to a 9-year high of 2.0% - right at the ECB’s inflation target - for the 10-year CPI swap rate. In the US, the survey-based measures of inflation expectations are telling a similar story. The New York Fed’s Consumer Survey shows that median 3-year expectations are now at 4.2% with 1-year expectations even higher at 5.7% (Chart 3). Meanwhile, the early November read on inflation expectations from the University of Michigan survey showed that 1-year-ahead expectations climbed to a 13-year high of 4.9%, while the longer-term 5-10 year inflation expectations were unchanged from the October reading of 2.9%. Chart 2Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Chart 3A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation The latter figure may provide some comfort to the Fed, with surging shorter-term expectations not fully leaking through into longer-term expectations. However, the longer the inflation upturn persists, the more likely it will be that US consumers begin to factor in a higher rate of longer-term inflation, just as TIPS traders are doing. After all, the Michigan 5-10 year measure has still climbed by 0.7 percentage points from the pre-COVID low. Even more worrying from the Fed’s perspective is that inflation expectations are rising for essentially all Americans. The New York Fed Consumer Survey shows that 3-year-ahead inflation expectations are rising across all levels of education (Chart 4) and income cohorts (Chart 5). Chart 4US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... Chart 5...And Income Levels ...And Income Levels ...And Income Levels The New York Fed also compiles a measure of consumer inflation uncertainty (bottom panels of both charts on page 5). Survey participants are asked to provide probabilities of inflation falling within certain ranges, with the gap between the top and bottom quartiles of those expected inflation outcomes representing the “uncertainty” over future US inflation. Perhaps unsurprisingly, the dispersion of inflation forecasts is typically much wider for those earning lower incomes and with less education. Yet even highly educated, high earning Americans are reporting wider gaps in possible inflation outcomes, in sharp contrast to the pre-COVID years where their expectations were low and stable. Americans Are Having Second Thoughts About The Fed Any way you cut it – TIPS breakevens or survey-based measures - US inflation uncertainty and volatility have increased. This appears to be starting to erode public confidence with the Fed. Along with its consumer confidence surveys, the University of Michigan also publishes a periodic survey of Confidence In Financial Institutions like commercial banks, asset managers and, most importantly, the Fed. The last survey was just conducted for the September/October 2021 period and showed that 43% of respondents reported a loss of confidence in the Fed compared to five years ago (Chart 6). That is up from 36% reporting a loss of confidence in the last such survey conducted in 2019, and is approaching the +50% levels seen in 2008 (the Financial Crisis) and in 2011 (the Taper Tantrum) – episodes where the Fed had difficulty maintaining economic and financial stability. Chart 6 The University of Michigan also noted that reported consumer confidence was much lower for those claiming to have less confidence in the Fed, and vice versa (Chart 7). Chart 7 Taken at face value, this survey shows that the Great Inflation of 2021 has shaken the public’s faith in the Fed’s ability to maintain economic stability. Combined with the message from the New York Fed Consumer Survey on the growing instability of American inflation expectations, this shows that the Fed may be facing an uphill climb to restore some of the credibility it has lost this year. Much like all aspects of American life these days, political partisanship must be factored in the analysis of US confidence data. The regular monthly University of Michigan sentiment survey for November noted that various measures of US confidence were consistently higher for respondents who reported to be Democrats compared to Republicans since President Biden took office (Chart 8). This is a mirror image of the years under President Trump (pre-pandemic), where Republicans consistently reported greater optimism than Democrats. Chart 8 Chart 9Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad The University of Michigan Confidence in Financial Institutions survey also noted that less trust in the Fed was reported more frequently by Republicans (67%) than Democrats (27%) in 2021, the first year under Biden. This compares to 2017, the first year of the Trump Administration, where more Democrats (41%) reported less trust with the Fed compared to Republicans (30%). The Michigan survey described this “partisan identification” as being a “significant correlate of consumer assessments of the Federal Reserve, treating the Fed as part of the administration rather than an independent body.” Consumer confidence among reported Democrats has been falling since April of this year, although there is still room to catch up to the complete collapse of sentiment seen among Republican consumers (Chart 9, top panel). High US inflation is hitting everyone hard. The surge in inflation expectations is overwhelming income expectations for the next year, according to the New York Fed Consumer Survey (middle panel). High realized inflation has also eroded real spending power, with real average hourly earnings having contracted in year-over-year terms since April of this year (bottom panel). Even with that fall in real income growth perceptions, the plunge in the University of Michigan US consumer confidence has not been matched by other measures like the Conference Board US consumer confidence index, which remains well above pandemic era lows. Even more importantly, US consumer spending has held up well, with nominal retail sales expanding by +1.7% in October following a +0.8% gain in September. Some of those increases were due to rising prices, but were still significantly above inflation in both months, suggesting a solid pace of real consumer spending (the headline US CPI index rose +0.9% and +0.4% in October and September, respectively). For the Fed, the case is building to begin preparing Americans for higher interest rates in 2022. This is true both from an economic perspective – the US economy is likely to continue growing above trend next year, further tightening the US labor market – and in response to the high inflation that has caused some damage to the Fed’s credibility. What About The UK And Euro Area? Looking across the Atlantic, survey-based measures of inflation expectations have also climbed steadily higher (Chart 10). The YouGov/Citigroup survey of UK consumer inflation expectations is now at 4.4% for the 1-year-ahead measure and 3.7% for the longer-run 5-10 year ahead measure, both well above the BoE’s 2% inflation target. The European Commission surveys show a rapidly rising share of European Union businesses and consumers expect higher prices in the coming months. Yet while inflation expectations are rising in both the UK and Europe, only the UK shows the sort of deterioration in central bank confidence that is evident in the US. 48% of Europeans expressed confidence in the ECB, according to the Eurobarometer public opinion surveys – the highest share since 2007 and well above the 36% level seen after the Global Financial Crisis and European Debt Crisis (Chart 11). Some of that improvement in perceptions of the ECB mirrors better sentiment over the euro currency itself, as evidenced by that fact that both Germans and Italians now express similar levels of ECB confidence. Chart 10High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US Chart 11Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB High levels of public trust in the ECB play an important role in anchoring European inflation expectations. The ECB introduced its own Consumer Expectations Survey as a pilot project last year, and the latest reading from October 2021 shows that 1-year-ahead inflation expectations are now at 3% and 3-year-ahead expectations are at 2%. Both measures were at 2% a year earlier, and have generally stayed close to ECB’s 2% inflation target since the survey began. Chart 12High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE A recent research report from the Bank of Finland concluded that European consumers who have high trust in the ECB adjust their medium-term inflation expectations more slowly than those with low trust. The high public confidence in the ECB seen in the Eurobarometer surveys, combined with the stability of medium-term inflation expectations (both survey-based and market-based) around the ECB’s 2% target – even with realized euro area inflation now at 3.4% - fits with the conclusions of that report. We read this as a sign that the ECB is not under the same growing pressure to tighten policy in the face of rising inflation as the Fed, which is facing an erosion of public confidence that is showing up in steadily rising inflation expectations. In the UK, the Bank of England (BoE) is facing a situation more akin to that of the Fed. The BoE’s Inflation Attitudes Survey has been showing a steady erosion of UK consumers reporting satisfaction with how the BoE has been setting policy to fight inflation (Chart 12). The “net satisfied” index fell to +18% in the last survey published in September – similarly low levels of BoE satisfaction coincided with major spikes in longer-term UK inflation expectations in 2008 and 2011 (bottom panel). Our conclusion from the UK consumer surveys, along with measures of inflation expectations that are well above the BoE medium-term target, is similar to that in the US. The UK public is losing faith in the BoE’s ability, or willingness, to tackle the high inflation “problem” – even if much of the inflation is caused by high energy prices and global supply chain disruptions that are beyond the immediate control of monetary policy. The BoE will likely need to follow through on the rate hikes markets expect in 2022 to help restore public trust and credibility, even if realized inflation slows from current elevated levels. This is especially true after the debacle of the November 4 BoE meeting where a widely-signaled rate hike did not occur. If the BoE continues to delay the start of tightening while inflation expectations are accelerating, this will only put more pressure on the central bank to tighten faster, and by more than expected, in a bid to stabilize inflation expectations. Investment Conclusions Chart 13Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Our read of the various surveys shows that public trust in central banks has deteriorated in the US and UK, but not in Europe, because of surging inflation in 2021. This compounds the existing trends of tightening labor markets and accelerating wage growth in the US and UK that are more traditional reasons to tighten monetary policy. We continue to favor strategic overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23 in order to restore public trust in the Fed and BoE (Chart 13). The ECB can continue to be patient on responding to higher euro area inflation, given more stable euro area inflation expectations and with limited evidence that higher realized inflation is boosting European wage growth. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Duration & Country Allocation: Global bond yields have been driven by growth and inflation expectations over the past year, but shifting policy expectations are now the more important driver. Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Inflation-Linked Bonds: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe. Downgrade strategic (6-18 months) exposure to inflation-linked bonds (vs nominals) to underweight in Germany, France and Italy. Feature Chart of the WeekGlobal Bond Yield Drivers: Inflation Now, Labor Later Global Bond Yield Drivers: Inflation Now, Labor Later Global Bond Yield Drivers: Inflation Now, Labor Later “Actually, we talked about inflation, inflation, inflation. That has been a topic that has occupied a lot of our time and a lot of our debates.” – ECB President Christine Lagarde Are you tired of talking about inflation? Central bankers likely are. The only problem is that is the job of monetary policymakers to worry about inflation – and the appropriate policy response – when it is rising as fast as been the case in 2021. The current global inflation surge, on the back of supply squeezes for both durable goods and commodity prices, will ease to some degree in 2022. This does not mean, however, that global bond yields have seen their cyclical peak. The driver of higher yields is already starting to transition from high inflation to tightening labor markets and rising wage costs – more enduring sources of potential inflation that will require monetary tightening in many, but not all, countries (Chart of the Week). This week, we discuss the implications of this shift to more policy-driven yields for the country allocation decisions in a government bond portfolio, for both nominal and inflation-linked debt. Shorter-Term Bond Yields Awaken, Longer-Term Yields Take Notice October represented a shift in the relative performance of developed economy government bond markets compared to the previous three months, most notably at the extremes (Chart 2). UK Gilts were the largest underperformer in Q3, down 1.8% versus the Bloomberg Global Treasury index (in USD-hedged terms, duration-matched to the benchmark), while Spain (+0.7%), Australia (+0.4%) and Italy (+0.3%) were the outperformers. In October, that script was flipped with Gilts being the best performer (+2.3%), Australia being the worst performer (-4.2%) and Spain (-0.6%) and Italy (-1.5%) reversing the Q3 gains. Chart 2 Those particular swings in relative performance were a result of shifting market views on policy changes in those countries. The UK Gilt rally was largely contained to a single day, and focused at the long-end of the Gilt curve after the Conservative government announced a smaller-than-expected budget deficit on October 26 - with much less issuance of longer-maturity bonds – which triggered a huge -22bps decline in 30-year Gilt yields. The Australian bond selloff was a triggered by a rapid market reassessment of the next move in monetary policy for the Reserve Bank of Australia (RBA) after an upside surprise on Q3 inflation data. Italian and Spanish debt also sold off on the back of growing fears that even the European Central Bank (ECB) would be forced to tighten policy in response to higher inflation. The backup in Australian and European yields ran counter to the latest policy guidance of from the RBA and ECB, indicating speculation of a bond-bearish hawkish policy shift. In countries where policymakers have been more explicit about the need for monetary tightening, like Canada and New Zealand, government bonds performed poorly in both Q3 and October. While US Treasury returns were “flattish” in both Q3 (0.1%) and October (0.1%), the 2-year Treasury yield doubled from 0.27% to 0.52% during October as the market pulled forward the timing and pace of Fed rate hikes starting next year (Chart 3). Shifting views on monetary policy have not only impacted the relative performance of bond markets, but also the shapes of yield curves. The bigger increases seen in shorter-maturity bond yields have resulted in a fairly synchronized global move towards curve flattening (Chart 4). This would not be unusual during an actual monetary policy tightening cycle involving rate hikes. However, within the developed economies, only Norway and New Zealand have seen an actual rate hike. In other words, yield curves have been flattening on the anticipation of a rate hiking cycle – but one that is expected to be relative mild. Chart 3A Bond-Bearish Repricing Of Global Rate Expectations A Bond-Bearish Repricing Of Global Rate Expectations A Bond-Bearish Repricing Of Global Rate Expectations ​​​​​​ Chart 4Some Violent Repricing Of Policy Expectations Some Violent Repricing Of Policy Expectations Some Violent Repricing Of Policy Expectations ​​​​​​ Forward interest rates in Overnight Index Swap (OIS) curves are discounting higher rates in 2022 and 2023 across most countries, but with stable rates in 2024 (Chart 5). Yet the cumulative amounts of tightening are very modest, especially when compared to inflation (both realized and expected). Only in New Zealand are policy rates expected to go above 2% by 2023, with the US OIS curve discounting the Fed lifting policy rates to just 1.4%. In the UK, markets are discounting 123bps of hikes by the end of 2022 and a rate cut in 2024 – market pricing that strongly suggests that the Bank of England will make a “policy error” by tightening too much, too quickly, over the next year. Chart 5Markets Still Think Central Banks Will Not Have To Hike Much Markets Still Think Central Banks Will Not Have To Hike Much Markets Still Think Central Banks Will Not Have To Hike Much After the October repricing of rate expectations, and reshaping of yield curves, we see a few conclusions – and investment opportunities – that stand out: US Treasuries With the Fed set to begin tapering asset purchases, the market discussion has moved on to the timing and pace of the post-taper rate hike cycle. The US OIS curve is discounting two Fed hikes in the second half of 2022, starting shortly after the likely end of the Fed taper in June. That timing and pace for 2022 is a bit more aggressive than we are expecting, but a rapidly tightening US labor market and rising wage growth could force the Fed to at least match the market pricing for hikes next year. On that note – the US Employment Cost Index in Q3 rose +1.3%, the fastest quarterly pace since 2001, and +3.7% on a year-over-year basis, the highest since 2004. The greater medium-term risk for the Treasury market is that the Fed starts to signal a need to go higher and faster than the market expects in 2023 and even into 2024. US Treasury yields remain well below levels implied by growth indicators like the ISM index. Thus, there is upside potential as the Fed tightens because of persistent above-trend growth and falling unemployment over the next couple of years (Chart 6). Chart 6Stay Below-Benchmark On US Duration Exposure Stay Below-Benchmark On US Duration Exposure Stay Below-Benchmark On US Duration Exposure We continue to recommend a below-benchmark duration strategic stance for dedicated US bond investors, based on our expectation that US bond yields will climb higher over the next 12-18 months. However, our more preferred way to play this for global investors is as a spread trade versus euro area bond yields – specifically, selling 10-year US Treasury versus 10-year German bunds (Chart 7). Chart 7Position For UST Underperformance Vs. Europe Position For UST Underperformance Vs. Europe Position For UST Underperformance Vs. Europe ​​​​​​ While headline inflation in the euro area has rapidly converged to the pace of US inflation over the past few months, this is overwhelmingly due to surging European energy costs. The pace of underlying inflation, as proxied by measures like the Cleveland Fed trimmed mean CPI and the euro area trimmed mean CPI constructed by our colleagues at BCA Research European Investment Strategy, has diverged sharply with the latter barely above 0%. The ECB will not follow the Fed into a rate hiking cycle next year, which will push US government yields higher versus European equivalents. Australia Government Bonds Chart 8Fade The RBA 'Rate Shock' In Australia Fade The RBA 'Rate Shock' In Australia Fade The RBA 'Rate Shock' In Australia The RBA fought back against the sharp repricing of Australian interest rate expectations earlier this week by signaling that no rate hikes are expected until 2023. This is a modest change from the previous forward guidance of 2024 liftoff, but a surprisingly dovish message for markets that had rapidly moved to price in rate hikes next year after the big upside surprise on Q3/2021 Australian inflation With underlying trimmed mean inflation now having crept back into the RBA’s 2-3% target range, although just barely at 2.1%, the RBA would be justified in removing some degree of monetary accommodation. The central bank has already been doing so, on the margin, with some earlier tapering of the pace of asset purchases and last week’s decision to formally abandon its yield control target on shorter-dated government bond yields. Per the RBA’s current forward guidance, however, a move to actual rate hikes would require more evidence of tighter labor markets and faster wage growth – and thus, a more sustainable move to the 2-3% inflation target - that is not yet evident in measures like the Wage Cost Index (Chart 8). We plan on doing a deeper dive into Australia for next week’s report, where we’ll more formally evaluate our strategic view on Australian bond markets. For now, we remain comfortable with our overweight stance on Australian government bonds, as the RBA is still projected to be one of the less hawkish central banks in 2022. UK Gilts Chart 9 The sharp rally in longer-dated UK Gilts seen at the end of October was due to a downside surprise in the expected size of the UK budget deficit next year, and the amount of Gilt issuance that will be needed to finance it. The UK Debt Management Office (DMO) said it planned to issue 194.8 billion pounds ($267.5 billion) of bonds in the current 2021/22 financial year, 57.8 billion pounds less than its previous remit back in March. The pre-budget market expectation was for a far smaller reduction of 33.8 billion pounds. The cut in issuance was most pronounced for longer-dated Gilts, -35% lower than the March budget issuance projection (Chart 9). With longer-maturity Gilts always in high demand from longer-term UK institutional investors, a major “supply shock” of reduced issuance can temporarily boost bond prices and lower yields. This is especially true in the UK where more aggressive rate hike expectations, and more defensive bond market positioning after the August/September selloff, left Gilts vulnerable to a short squeeze. The most important medium-term drivers of Gilt yields are still expectations of growth, inflation and future policy rates. There was very little change in shorter-dated Gilt yields or UK OIS forward rates after last week’s budget announcement – all the price action was the long end of the Gilt yield curve, resulting in an overall bull flattening. As we discussed in last week’s report, we expect the next move in the shape of the Gilt curve will be towards a steeper curve, likely bond-bearishly as long-term yields are still priced too low relative to how high UK policy rates will eventually have to climb in the upcoming BoE hiking cycle. The post-budget flattening has made the valuation of longer-maturity Gilt curve steepeners far more attractive, according to our UK butterfly spread valuation model (Table 1). Table 1UK Butterfly Spread Valuations From Our Curve Models Transitioning From Inflation To Policy As The Driver Of Bond Yields Transitioning From Inflation To Policy As The Driver Of Bond Yields Chart 10A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell The trade that stands out as most attractive is to go long the 10-year Gilt bullet versus selling a 7-year/30-year Gilt curve barbell – a butterfly spread that was last priced this attractively in 2013 (Chart 10). We are adding this as a new recommended trade in our Tactical Overlay portfolio, the details of which (specific bonds and weightings for each leg of the trade) can be found on page 17. Bottom Line: Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Global Breakevens: How Much More Upside? The surge in global inflation this year has helped boost the performance of inflation-linked government bonds versus nominal equivalents. Yet current breakeven inflation rates have reached levels not seen in some time. Last week, the 10-year US TIPS breakeven hit a 15-year high of 2.7%, the 10-year German breakeven reached a 9-year high of 2.1%, while the 10-year UK breakeven climbed to 4.2% - the highest level since 1996 (!). With market-based inflation expectations reaching such historically high levels, how much more can breakevens widen – especially with central banks incrementally moving towards tighter monetary policies? To answer that question, we turn to our Comprehensive Breakeven Indicators (CBIs). The CBIs measure the upside/downside potential for breakevens for the US, Germany, France, Italy, Japan, the UK, Canada and Australia. The CBIs incorporate the following three measures: The residuals from our 10-year breakeven inflation spread fair value models, as a measure of valuation. The spread between 10-year breakevens and survey-based measures of inflation expectations, as a measure of the inflation risk premium embedded in breakevens The gap between headline inflation and the central bank inflation target, as an indication of the existing inflation backdrop and of future monetary policy moves in response to an inflation trend that can help to reverse that trend. Each of the three measures is standardized and added together to produce a single CBI. A higher reading on CBI suggests less potential for additional increases in breakevens, and vice versa. The latest readings from our CBIs are shown in Chart 11. The red diamonds for each country are the actual CBI, while the stacked bars show the individual CBI components. The highest CBI readings are in Germany and the US, while the lowest are in Canada and France. Importantly, no country has a CBI significantly below zero, indicative of the more limited upside potential for breakevens after the big run-up since mid-2020. Chart 11 As a way to assess the usefulness of the CBIs as an indicator of the future breakeven moves, we constructed a simple backtest. We looked at how 10-year breakevens performed in the twelve months after the CBI hit certain thresholds (Chart 12). The backtest results show that the CBIs work as intended, signaling reversals of existing trends once the CBIs climb above +0.5 or below -0.5. The average (mean) size of the breakeven reversal gets larger as the CBI moves further to extremes. Chart 12 Based on the latest reading from the CBIs, we are making significant changes to the recommended allocations (Chart 13) to inflation-linked bonds (ILBs) in our model bond portfolio on pages 14-15: Chart 13No Overweights In Our Revised Allocations To Global Linkers No Overweights In Our Revised Allocations To Global Linkers No Overweights In Our Revised Allocations To Global Linkers Downgrading ILBs to underweight (versus nominal government bonds) in Germany, France, Italy & Spain from the current overweight allocation. The backtested CBI history for those countries suggests breakevens are more likely to fall over the next twelve months. Furthermore, realized euro area inflation is more likely to fall in 2022, given the lack of underlying euro area inflation described earlier in this report. Downgrade Japan ILBs to neutral from overweight. While the CBI is not at a stretched level, realized Japanese core inflation has struggled to stay in positive territory – even in the current environment of soaring commodity and durable goods prices. Upgrade ILBs in Canada and Australia to neutral from underweight. The former has a CBI that is still below zero, while the latter benefits from the lack of RBA hawkishness compared to other central banks. We are maintaining our other ILB allocations in the UK (underweight vs. nominals) and the US (neutral vs. nominals). In the UK, stretched breakevens are at risk from the hawkish turn by the BoE, which is a clear response to the higher UK inflation expectations. While the US CBI is at a high level, we see better value in playing for narrowing TIPS breakevens at shorter maturity points that are even more exposed to a likely slowing of commodity fueled inflation in 2022 than longer maturity TIPS breakevens. In other words, we see a steeper US breakeven curve, but a flatter real yield curve as the Fed tightens. Bottom Line: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.co Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Energy Prices & Bond Yields: Surging energy prices are lifting inflation expectations in the US and Europe, while at the same time dampening consumer confidence amid diminished perceptions of real purchasing power. These conflicting trends are putting central banks in a tricky spot in the near-term, but tightening labor markets will force a more enduring need for dialing back global monetary accommodation in 2022, led by the Fed and the Bank of England. Stay below-benchmark on global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. High-Yield: Trans-Atlantic junk bond performance has diverged of late, with euro area spreads widening versus the US. This is a temporary distortion created by the pop in oil prices, with the Energy sector that benefits from higher oil prices representing a far greater share of the high-yield universe in the US compared to Europe. Maintain an overweight stance on European high-yield corporates. Feature Chart of the WeekGlobal Bond Yield Breakout? Global Bond Yield Breakout? Global Bond Yield Breakout? It is not easy being an inflation-targeting central bank these days. Soaring energy prices, with the Brent crude benchmark price climbing to a 3-year high of $86/bbl last week and natural gas prices up nearly four-fold year-to-date in Europe. These moves are adding upward pressure to inflation rates already elevated because of disrupted supply chains and rising labor costs. Government bond yields in the developed markets are moving higher in response, driven by rising inflation breakevens and increasing central bank hawkishness that is causing a stir in negative real yields (Chart of the Week). Among the three most important developed economy central banks - the Fed, the ECB and the Bank of England (BoE) – the most forceful signaling of a need for tighter policy is surprisingly coming from Threadneedle Street in London, home to one of the most dovish central banks since the 2008 crisis. Numerous BoE officials, including Governor Andrew Bailey, have strongly hinted that UK rate hikes could begin as soon as next month’s policy meeting. Fed officials have suggested a similar timetable for the start of the QE taper. By contrast, members of the ECB Governing Council have paid lip service to the recent sharp pickup in euro area inflation but, for the most part, have stuck to the view that it will not last long enough to justify a policy response. The relative hawkishness among “The Big Three” central banks fits with our current recommended strategy on global duration exposure, staying below-benchmark, and country allocation, with the largest underweights to US Treasuries and UK Gilts. Should Central Banks Focus More On Inflation Or Growth? Monetary policymakers are in a difficult spot at the moment. Rising energy prices have breathed new life into inflation, and inflation expectations, even as global growth momentum has cooled off somewhat. Given the magnitude and breadth of the global energy price surge – even coal prices in China have shot up 120% since late August - it will be difficult for central bankers to “see through” the inflationary implications and worry more about growth (Chart 2). Rising energy prices are likely to extend the current global inflation upturn that has already gone on for longer than expected because of supply-chain disruptions. This raises the risk that consumers could turn more cautious on spending behavior if they have to devote more of their incomes just to fuel their cars or heat their homes. In the US, this dynamic already appears to be playing out. The acceleration of inflation has broadened out, with the Cleveland Fed’s trimmed mean CPI inflation measure (which removes the most volatile components of the CPI) rising to 3.5% in September (Chart 3, top panel). With US consumers seeing higher prices on a wider range of goods and services, they have raised their inflation expectations. The preliminary October University of Michigan US consumer confidence survey showed that 1-year-ahead inflation expectations rose to a 13-year high of 4.8% (middle panel). Chart 2Pouring Gas On Global Inflation Pouring Gas On Global Inflation Pouring Gas On Global Inflation The New York Fed’s consumer survey showed a similar 1-year-ahead inflation forecast (5.3%), which is well above the forecast for income growth in 2022 (2.9%). Combining those two measures shows that US consumers implicitly see a contraction in their real incomes over the next 12 months. Chart 3US Consumers Expect A Sharp Decline In Real Purchasing Power US Consumers Expect A Sharp Decline In Real Purchasing Power US Consumers Expect A Sharp Decline In Real Purchasing Power This has likely played a big role in the sharp fall in the University of Michigan consumer confidence index since the peak back in June (bottom panel), despite favorable US labor market conditions. US consumer perceptions of inflation appear much greater than the reality of inflation evident in the official price indices. The New York Fed survey also asks US consumers what their 1-year-ahead expectations are for major spending categories, like food or rent (Chart 4). Consumers expect somewhat slower inflation for food (7.0%) and gasoline (5.9%) over the next year, yet they also expect much higher medical care costs (9.4%) and rent (9.7%). For the latter two, those are considerably higher than the latest actual inflation rates seen in the US CPI (2.4% for rent, 0.4% for medical care) or PCE deflator (2.1% for rent, 2.4% for medical care). Taking these survey results at face value, it is likely that US consumers are overestimating how much their real incomes will suffer next year from higher inflation. This is especially true as US household income growth will likely surpass the 2.9% estimate seen in the New York Fed survey. Yet that does not preclude the Fed from starting to turn more hawkish. Central bankers are always on the lookout for signs that higher realized inflation is feeding through into rising inflation expectations, which could require a policy tightening response to prevent an overshoot of inflation targets. The Fed has given itself a bit more leeway in that regard by altering their policy framework to allow temporary deviations of inflation from the central bank targets. The BoE, however, has not given itself the same sort of flexibility, which is why it is now signaling an imminent rate hike in response to survey-based inflation expectations, and breakeven inflation rates on longer-dated index-linked Gilts, climbing to close to 4% (Chart 5). Yet even the Fed, with its Average Inflation Targeting framework, has signaled that a tapering of its bond purchases will likely begin by year-end. Chart 4US Consumer Inflation Expectations Well Above Actual Inflation US Consumer Inflation Expectations Well Above Actual Inflation US Consumer Inflation Expectations Well Above Actual Inflation Markets are looking at the persistence of high inflation and have priced in a more hawkish trajectory for interest rates in the US, UK and even Europe over the next 12-24 months (Chart 6, bottom panel). Chart 5Inflation Weighing On UK & European Consumer Confidence Inflation Weighing On UK & European Consumer Confidence Inflation Weighing On UK & European Consumer Confidence Real bond yields in those regions are also starting to move higher in response to rising rate expectations (third panel) - a bond-bearish dynamic that we have discussed at length in recent reports.1 Between those three, the BoE’s hawkish turn has hammered the Gilt market the hardest. Yet there has definitely been a spillover into rate expectations and bond yields in other countries on the back of the BoE guidance. We have already seen rate hikes from smaller developed market central banks, Norway and New Zealand, over the past month. If a major central bank like the BoE soon follows suit because of overshooting inflation expectations, then markets are justified in thinking that the Fed or even the ECB could be next. Of those “Big 3” central banks, we see the ECB as being the least likely to respond to the current inflation upturn with rate hikes in 2022. There is simply not enough evidence suggesting that the energy/supply-chain driven inflation in the euro area is broadening out into other parts of the economy on a sustainable basis. Furthermore, there is already some degree of monetary tightening “scheduled” in 2022 when the ECB’s pandemic bond purchase program expires in March. The ECB will not want to compound that by moving into rate hiking mode soon after. On the other hand, the Fed will likely see enough further tightening of US labor market conditions to begin hiking rates in the fourth quarter of 2022 (Chart 7). In the UK, After next month’s likely rate hike, the BoE will need to deliver at least another 50-75bps of additional hikes in 2022 and likely more in 2023 with real policy rates already well below neutral before the latest spike in energy prices. Chart 6Expect Higher Real Yields As Central Banks Turn More Hawkish Expect Higher Real Yields As Central Banks Turn More Hawkish Expect Higher Real Yields As Central Banks Turn More Hawkish Chart 7Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 With the Fed and BoE set to be far more hawkish than the ECB next year, we see greater risks of government bond yields rising faster, and higher than current forward rates, in the US and UK compared to the euro area (Chart 8). This justifies an overall cautious strategic stance on duration exposure in global bond portfolios. With regards to inflation-linked bonds, however, we recommend only a neutral overall stance. Elevated inflation breakevens have converged to, or even above, central bank inflation targets in all developed market economies (excluding Japan). 10-year UK breakevens, in particular, look very expensive on our fair value model (Chart 9). Chart 8Our Recommended "Big 3" Country Allocations Our Recommended 'Big 3' Country Allocations Our Recommended 'Big 3' Country Allocations Chart 9Maintain An Overall Neutral Stance On Inflation-Linked Bonds Maintain An Overall Neutral Stance On Inflation-Linked Bonds Maintain An Overall Neutral Stance On Inflation-Linked Bonds Bottom Line: Our view on the policy decisions of the Big 3 central banks in 2022 informs our strategic (6-18 months) investment strategy within those markets. Stay below-benchmark on overall global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. Fade The Recent Backup In European High Yield Spreads Chart 10A Slight Pickup In European Junk Spreads A Slight Pickup In European Junk Spreads A Slight Pickup In European Junk Spreads Corporate credit markets in the US and Europe have calmed down since the July/August “Delta fueled” selloff with one notable exception – European high-yield (HY). The Bloomberg European HY index spread now sits 39bps above the September low, noticeably diverging from the US HY index spread (Chart 10). We view those wider spreads as a tactical buying opportunity for European junk bonds, both in absolute terms and versus US junk bonds. The recent underperformance appears rooted in soaring European energy prices. The spread widening has been concentrated in European consumer sectors (both cyclicals and non-cyclicals) that would be more exposed to the drain on real incomes from booming natural gas prices. Energy is also a smaller part of the European high-yield index (2%) compared to the US HY index (13%), which helps explain the performance gap with the US – the US index is more exposed to companies that benefit from higher energy prices (Chart 11). Chart 11Sectoral Breakdown Of US & Euro Area High-Yield Indices Central Banks Backed Into A Corner Central Banks Backed Into A Corner Over a more medium-term perspective, there is little reason why there should be a meaningful performance difference between US and European HY. The path of spreads and excess returns (versus duration-matched government debt) for the two markets have been highly correlated in recent years (Chart 12). When adjusting European HY returns to allow a proper apples-to-apples comparison to US HY – by hedging European returns into US dollars and controlling for duration differences between the two markets – there has been little sustained difference in returns dating back to 2018. Chart 12Euro Area HY Has Closed The Gap Vs. The US Euro Area HY Has Closed The Gap Vs. The US Euro Area HY Has Closed The Gap Vs. The US Chart 13Junk Default Rates Will Stay Low In 2022 Central Banks Backed Into A Corner Central Banks Backed Into A Corner More fundamentally, there is little difference in default rates that would justify a major divergence of HY spreads on both sides of the Atlantic. Moody’s is forecasting a HY default rate for a rate of 2% in both the US and Europe for 2022 (Chart 13). Such similar default rate expectations make sense with economic growth likely to remain well above trend in 2022 in both the US and Europe. Higher inflation will also boost nominal GDP growth, helping lift corporate revenues and the ability to service debt. From a valuation perspective, there is also little to choose from between European and US HY: The default-adjusted spread, which takes the current HY index spread and subtracts expected default losses over the next twelve months, is 196bps in Europe and 166bps in the US (Chart 14). While those spreads are below the post-2000 mean in both markets, they are still above past valuation extremes. The percentile ranking of 12-month breakeven spreads (the amount of spread widening over one year that would eliminate the yield advantage of HY over duration-matched government bonds) are also similar, 25% for European HY and 26% for US HY (Chart 15). These suggest HY spreads are not particularly “cheap”, from a historical perspective, in either market, but they could move lower to reach previous historical extremes. Chart 14Low Expected Default Losses Supporting HY Valuations Low Expected Default Losses Supporting HY Valuations Low Expected Default Losses Supporting HY Valuations Chart 15Overall HY Spreads Are Tight In The US & Europe Overall HY Spreads Are Tight In The US & Europe Overall HY Spreads Are Tight In The US & Europe Chart 16Euro Area Ba-Rated HY Spreads Look More Attractive Central Banks Backed Into A Corner Central Banks Backed Into A Corner Summing it all up, there is no discernable reason why European HY should trade at a sustainably wider spread to US HY, outside of the compositional issue related to the weight of the Energy sector in both markets. When breaking down the two markets by credit rating buckets, European Ba-rated corporates even look more attractive versus similarly-rated US corporates, based on 12-month breakeven spread percentile rankings (Chart 16). Bottom Line: Maintain a strategic overweight stance on European high-yield corporates, and tactically position for some relatively better performance of European junk bonds versus US equivalents.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "What If Higher Inflation Is Not Transitory?", dated September 23, 2021, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning   Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Central Banks Backed Into A Corner Central Banks Backed Into A Corner The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, There will be no weekly report next week. Instead, we will host our quarterly webcast on Tuesday, October 26 for the US and EMEA regions and Wednesday, October 27 for the Asia Pacific region. We will resume our regular publishing schedule on Monday, November 1. In the meantime, we look forward to seeing many of you at our BCA Research Investment Conference this week. Best regards, Mathieu Savary   Highlights This year’s decline in EUR/USD has rendered this pair sufficiently inexpensive and oversold to account for the near-term risks we highlighted in March. Nonetheless, some risks remain—among them, the continued credit slowdown in China, diverging monetary policy trends, and the energy crisis hurting Europe. However, long-term fundamentals continue to support the euro’s 12- to 18-month outlook. Moreover, Chinese credit growth may soon stabilize and markets already largely factor in the policy divergence between the Fed and the ECB. As a result, we buy the euro today with a preliminary target at 1.25 and a stop loss at 1.1175. The Bank of England will lift rates this December, but the market already prices in a hawkish BoE. GBP/USD has upside, even if the euro should outpace the pound in the coming months. Look to upgrade UK small-cap stocks. Italian equities do not appear particularly appealing on a cyclical horizon, neither in absolute nor relative terms. Investors should favor Spanish stocks over Italian ones for the next 12-to-18 months. Feature EUR/USD recently flirted with 1.15. Did this move create a buying opportunity? Last March, we warned that the euro would correct to the 1.12 to 1.15 zone because short-term models flagged it as expensive, speculators carried a substantial net-long exposure, and Chinese credit growth was set to slow meaningfully. These forces have now mostly played out; thus, the euro’s near-term outlook is becoming more positive. Despite this more constructive view, EUR/USD still carries ample downside risks, especially if Chinese authorities remain reluctant to reflate their economy. Moreover, the energy crisis facing Europe clouds the euro. We are nonetheless buyers of EUR/USD, with a target at 1.25. Investors should set a wide stop in at 1.1175. Cheap And Oversold The internal dynamics of the euro indicate that the bulk of the sell-off is behind us. First, the euro is now cheap on a tactical basis. Back in March, our short-term fair value model for EUR/USD flagged at 7% overvaluation based on real rate differentials, on the slope of the German yield curve relative to that of the US, and on the copper-to-lumber prices ratio. Today, this same measure shows a 5% undervaluation. BCA’s Foreign Exchange Strategy Intermediate Term Timing Model (ITTM) flags an even clearer buy signal.  The ITTM framework combines interest rate parity models, with risk aversion and considerations for the currency’s trend. Currently, this model is at -8% or nearly minus one standard error. Historically, such a depressed reading points to generous returns in the subsequent 12 months (Chart 1). Second, the euro is oversold. BCA’s Intermediate Term Technical Indicator has hit 7, which is consistent with past rebounds in EUR/USD (Chart 2). While some of these rallies have been extremely short-lived, the technical indicator’s message is stronger when it is matched by a buy signal from the ITTM. Chart 1Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Chart 2EUR/USD is Oversold EUR/USD is Oversold EUR/USD is Oversold Chart 3Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Third, speculators do not carry a large net long position in the euro anymore. This variable suggests that the worst of the selling pressure is behind us, but it has yet to send a strong buy signal on its own (Chart 3). Bottom Line: The euro is sufficiently inexpensive that our Intermediate-term timing model flags a strong buy signal. Moreover, our technical indicators paint an oversold picture consistent with a reversal. Nonetheless, speculators may not be long EUR/USD anymore, but they are not aggressively selling it either. Thus, macro dynamics remain important to the future trend of this currency. Macro Fog Remains The macro environment is not yet conducive to a euro rally, especially when Chinese credit growth remains weak. However, considering the euro’s valuation and technical picture, small changes in the macro environment could be enough to catalyze a jump in EUR/USD. A key problem for the euro is that the dollar remains well bid. The yen and the dollar are the two momentum currencies within the G-10 (Chart 4). This property of the dollar is a large handicap for the euro, because it remains the most liquid vehicle to bet on the USD. Thus, as long as the dollar’s momentum is strong, the euro will find it difficult to rally. Relative economic growth is another headwind for EUR/USD. European activity is weakening versus that of the US. Since 2019, the relative manufacturing PMIs between the Euro Area and the US track EUR/USD, and they currently confirm the euro’s weakness (Chart 5). Moreover, European economic surprises are significantly weaker than US ones, which adds to the euro’s malaise (Chart 5, bottom panel). Chart 4The Dollar Is A Momentum Currency Time For The Euro To Shine? Time For The Euro To Shine? Chart 5Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD The near-term outlook does not signal a resolution of this issue until the first half of 2022. The declines in the expectation and current situation components of both the ZEW and Sentix surveys herald an additional deceleration in manufacturing activity (Chart 6). The Eurozone’s growth problems reflect China’s slowing credit flows. Europe economic activity is still extremely sensitive to the evolution of the global industrial cycle (Chart 7, top panel), much more so than the US GDP is. China’s business cycle is an essential determinant of the robustness of the global manufacturing sector. Consequently, when measures of China’s marginal propensity to consume decelerate, such as the gap between M1 and M2 growth, European PMIs and industrial production underperform those of the US (Chart 7, second and bottom panels). Chart 6A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends Chart 7China's Travails Hurt Europe China's Travails Hurt Europe China's Travails Hurt Europe     The fourth quarter of 2021 is likely to represent the tail end of the Chinese headwind on EUR/USD. The Chinese credit impulse remains weak, but signs of a floor are beginning to appear. For example, the decline in Chinese commercial banks excess reserve growth warned us of the coming decline in the credit impulse. Today, excess reserves have begun to stabilize, which points to an upcoming imporvement in credit flows (Chart 8). Additionally, the Evergrande problems continue to weigh on Europe in the near-term because of the deceleration in Chinese construction activity;  however, the crisis will also intensify the pressure on Beijing to revive credit growth in order to avoid a systemic collapse. Chart 8Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Monetary policy differentials also remain euro bearish. The US Federal Reserve will announce the start of its tapering program on November 3. The FOMC is set to hike rates by the end of 2022. Meanwhile, the ECB is unphased by the increase in European inflation, which remains mostly a reflection of energy prices and base effects. Thus, Europe will lag behind the US when it comes to monetary policy tightening. Nonetheless, investors already understand this dichotomy very well. The US OIS curve anticipates four hikes in 2023. Meanwhile, the EONIA curve shows a first 25-bps hike only by September 2023. Thus, the euro will suffer more from policy differentials if the Fed generates hawkish surprises relative to this pricing. The energy crisis shaking Europe is the last major headwind currently affecting the euro. Historically, EUR/USD and the ratio of European to US natural gas prices track each other (Chart 9). This relationship reflects relative growth dynamics. A stronger Eurozone economy relative to the US pushes up the value of the euro and European natural gas, which is a commodity with heavy industrial usage.  However, since this summer, the spike in European natural gas prices has coincided with a decline in the euro. This divergence highlights the negative effect on European activity of the current energy shock, which raises fears of stagflation. The cross-Atlantic bond market dynamics confirm the notion that the energy shock increases the perceived stagflation risk in the Eurozone. German yields have risen relative to US ones because of a pick-up in inflation expectations, not real rates (Chart 10). The lack of traction for relative real rates is appropriate because market participants believe that the ECB wants to ignore the spike in energy prices. An environment of rising relative inflation expectations but stable relative real rates is very negative for any currency, including the euro. However, European inflation expectations should decrease relative to those of the US once European natural gas prices normalize, which we expect to take place in the coming months (Chart 10, bottom panel). This process will be very positive for the euro. Chart 9The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro Chart 10Pricing In European Stagflation? Pricing In European Stagflation? Pricing In European Stagflation? Bottom Line: While euro pricing and technicals suggest EUR/USD will bottom soon, the economic environment is murkier. The dollar is a momentum currency, and its current strength feeds the euro’s weakness. China’s credit flows continue to decelerate, which hurts the euro; however, credit flows may stabilize in early 2022. The Fed is a tailwind for the dollar, but markets already price in this reality. Finally, the energy crisis hurts European growth and thus EUR/USD; nonetheless, the spike in natural gas prices will soon give way to a period of decline, which will lessen the pain for the euro. What To Do? When we balance the positives and negative for the euro, we are becoming more comfortable with buying EUR/USD outright, even if it is still a risky bet. To begin with, the big fundamental forces point to a firmer euro on an 18- to 24-month basis: BCA’s Foreign Exchange strategists see greater cyclical downside for the USD and believe the current rebound is a pronounced countertrend move within a multi-year dollar bear market. The euro will naturally benefit over the coming years from a weak greenback. EUR/USD is still inexpensive on long-term valuation metrics. Based on BCA’s purchasing power parity model, this pair trades 17% below its fair value. Moreover, the PPP estimate keeps rising in favor of the euro, a result of the Eurozone’s lower inflation compared to the US (Chart 11). The relative balance of payments favors the euro. The European economy generates a current account surplus of 3% of GDP compared to a current account deficit of 3.1% for the US. The US current account deficit is unlikely to narrow, even if the federal government’s budget hole declines because the private sector’s savings rate is falling even faster. Moreover, US real two-year rates remain well below those of its trading partners. Investors underweight Eurozone assets aggressively. For the past ten years, capital has consistently flowed out of the Euro Area relative to the US (Chart 12). European growth should converge toward the US next year, especially if Chinese credit activity stabilizes. Therefore, 2022 should witness a period of inflows into the Eurozone. Chart 11EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount Chart 12Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets We argued that the valuation and technical backdrop shows the Euro is becoming increasingly supportive and our timing model is clearly arguing against selling EUR/USD. However, the biggest technical risk is the momentum sensitivity of the dollar, which means that the euro’s weakness could last somewhat longer. Nevertheless, BCA’s Dollar Capitulation Index now warns of a pullback in the USD, especially as speculators are very long DXY futures (Chart 13). The biggest downside risk remains China’s credit trend. If it takes more time than we anticipate for Beijing to put an end to the credit impulse slowdown, the euro will experience greater downside pressure. Moreover, the longer it takes Beijing to reflate, the greater the chance of an uncontrolled selloff in the CNY, which would drag down the euro (Chart 14). Chart 13Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Chart 14China Remains The Euro's Main Risk China Remains The Euro's Main Risk China Remains The Euro's Main Risk Despite this level of near-term uncertainty, we recommend investors buy the euro, with a target at 1.25, and a stop loss at 1.1175. Bottom Line: Conditions are falling in place for the countertrend decline in the euro to end soon. As a result, the euro should converge back toward the upward path driven by fundamentals. The greatest near-term risk remains the path of Chinese credit trends. We recommend investors buy the euro with a preliminary target at EUR1.25 and a stop loss at 1.1175.   Country Focus: A Well Discounted BoE Hike The Bank of England will begin to increase interest rates at its December meeting. The BoE’s communication has been clear that it does not see a need to wait between the end of its tapering program in December and the beginning of its hiking campaign. Recent comments by senior MPC members, including new Chief Economist Huw Pill, also suggest a rate hike is looming. Chart 15The BoE's Inflation Problem The BoE's Inflation Problem The BoE's Inflation Problem We see little reason to doubt the willingness of the MPC to start lifting the Bank Rate. UK Core CPI stands at 3.1% or 110 basis points above the BoE’s inflation target. Moreover, both market-based and survey-based long-term inflation expectations are well above 3.5%, which increases the risk of a dangerous dis-anchoring of UK inflation (Chart 15). UK economic activity remains inflationary. Wages are strong, climbing 7.2% in August. This number probably exaggerates the underlying wage growth due to compositional effects, but job creation remains robust and the unemployment rate fell to 5.2%. The BoE was concerned that the end of the furlough scheme last month would cause a jump in unemployment, but their fears have dwindled, because job vacancies stand at a record high and capex intentions are solid (Chart 16). The housing market continues to be a tailwind to growth. House prices are up 10% annually, which lifts household net worth considerably (Chart 17). The pace of transactions in the real estate market will slow this spring because the stamp duty holiday will end; however, low mortgage rates and expectations of further housing gains may fuel greater appreciation. This creates long-term financial stability risks for the UK because household leverage will rise. This worries the BoE. Chart 16The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue Chart 17Rising Household Net Worth Rising Household Net Worth Rising Household Net Worth Market participants already expect a hawkish BoE. A rate hike is priced in for December and the SONIA curve embeds almost two more increases in 2022. The 4.3% underperformance of the UK government bond index over the global benchmark in seven weeks also underscores the rapid adjustment in investors’ perceptions of the UK policy path. BCA’s Global Fixed-Income strategists have underweighted UK government bonds for two months, and they maintain a negative view over the coming quarters.  Nonetheless, the risk of a short-lived countertrend rebound in UK bonds’ relative performance is significant. However, it would be a temporary position squaring, while hedge funds and CTAs take profits. BCA’s Foreign Exchange strategists expect GBP/USD to rebound. Cable is oversold and trades at a 12% discount to BCA’s PPP fair-value estimate. GBP/USD is also hurt by fears that the BoE hikes will damage the UK economy. From a contrarian perspective, this creates a positive entry point to buy cable, especially because the pound should benefit from the anticipated dollar weakness and the euro’s upcoming rally. However, BCA’s FX strategists also foresee some decline in the pound versus the euro, because GBP is a low beta play on EUR/USD. Hence, the trade-weighted pound could remain flat to slightly down in the coming months. We stay neutral on UK small-cap stocks relative to large-cap equities, but we are putting them on an upgrade alert. Small-cap stocks benefit from the strength in the domestic economy; however, they are also extremely expensive compared to large-cap ones (Chart 18). The arbiter of performance will be profits. The forward EPS of small-caps have lagged behind those of large-caps by 9% since the COVID recession, after underperforming since 2016 (Chart 19). Small-caps’ relative profits are currently trying to stabilize, but the durability of this trend will be tested if the trade-weighted pound remains flat in the coming months. Thus, the EPS of small-cap shares must regain more ground before moving more aggressively in this market. Chart 18UK Small Cap Are Pricey UK Small Cap Are Pricey UK Small Cap Are Pricey Chart 19Follow The Profits Follow The Profits Follow The Profits Bottom Line: On the back of a strong UK economy and significant inflationary forces, the BoE will start elevating interest rates this December. The market already prices in this outcome. Nonetheless, UK bonds should continue to underperform the global benchmark, and cable has upside, even if the near-term outlook favors the EUR over the GBP. We are putting UK small-cap stocks on a buy alert. They are expensive, but a turnaround in profits would solve this problem. Market Focus: A Quick Take On Italian Equities The Italian equity market remains Europe’s problem child. The Italian MSCI index has underperformed the rest of the Euro Area by 40% since 2010. This underperformance holds even after adjusting for sectoral differences, although it becomes less dramatic (Chart 20, top panel). Despite this underperformance, Italian equities have managed to outperform their Spanish counterparts by 27% since 2010, but this outperformance dissipates once sectoral difference are accounted for (Chart 20, bottom panel). The RoE of Italian non-financial listed equities is equivalent to the rest of the Eurozone, but it only reflects elevated financial leverage, as is the case in Spain (Chart 21). Italy’s RoA is poor, because Italy’s excess capital stocks hurts its return on capital. As a result, Italian equities continue to face a structural handicap. Chart 20A Problem Child A Problem Child A Problem Child Chart 21Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor The good run in Italian equities in absolute terms faces headwinds. Italian stocks are very sensitive to the global business cycle; however, they often respond with a delay and in an exaggerated fashion to decelerations in the global PMI (Chart 22, top panel). Moreover, since 2010, widening European high-yield corporate bond spreads have preceded falling Italian stock prices. Thus, the recent slide in the global PMI and the widening in European high-yield OAS create a period of vulnerability for Italian equities. Finally, Italian share prices have overshot the path implied by US yields (Chart 22, bottom panel). Nonetheless, Italian stocks may be sniffing out further increases in global yields. The cleanest way to play these vulnerabilities in the Italian is via a short bet against Spain. A steeper global yield curve will help both markets due to their heavy exposure to financials. However, we still favor Spanish financials, which benefit from higher RoEs than their Italian counterparts (Chart 23) and lower NPLs. As a result, the forward EPS of Spanish financials should begin to outperform those of Italian financials. Chart 22Some Risks To Italian Stocks Some Risks To Italian Stocks Some Risks To Italian Stocks Chart 23Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Cyclical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Structural Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Closed Trades Time For The Euro To Shine? Time For The Euro To Shine? Currency Performance Fixed Income Performance Equity Performance

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Chart 2Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 4… But The Nominal USD Value Rises Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 8 Uncertainty Weighs On Gold Uncertainty Weighs On Gold   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures Cyclical UST Curve Flattening Pressures Cyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Stay In Our 2/5/10 UST Butterfly Trade Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation ECB Will Not React To This Cyclical Bout Of Inflation ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based Euro Area Inflation Upturn Is Not Broad-Based Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade Close Our Long Dec/23 Euribor Futures Trade Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Enter A New 10yr UST-Bund Spread Widening Trade Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening UST-Bund Technical Backdrop Positioned For Widening UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread Relative Data Surprises Favor Wider UST-Bund Spread Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade Take Profits On Our Long 10yr French Breakevens Trade Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves An Inflation-Induced Bear Steepening Of Yield Curves An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model Inputs Into Our Australia-US Spread Model Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Market Expectations For The RBA Are Too Hawkish Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Go Long 10-Yr Australian Inflation Breakevens Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Thematic Update Of Our Tactical Trades A Thematic Update Of Our Tactical Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q3/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +8bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +4bps, led by the timely downgrade of UK Gilts to underweight in early August. Spread product allocations outperformed by +4bps, coming entirely from the overweights to high-yield in the US and Europe. Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries. Feature Global bond markets have had a lot of sources of uncertainty to digest over the past few months. Renewed COVID fears due to the spread of the Delta variant, slowing global growth momentum, supply chain disruptions leading to surging realized inflation, the ongoing US fiscal policy debate in D.C., concerns over Chinese corporate debt and the increasingly hawkish monetary policy signals sent by global central banks, most notably the Fed. The net result of these narratives has been some major swings in government bond market performance during the third quarter of 2021. The benchmark 10-year government bond yield in the US started the quarter at 1.48%, fell to an intraday low of 1.12% on August 4, then soared higher to end the quarter back at 1.50%. Even bigger moves were seen in other countries, with the 10-year UK Gilt yield doubling from its Q3 low of 0.48% on August 4 while the 10-year German bund yield is now 30bps above its low for the quarter. Despite this yield volatility, however, spreads for riskier credit market assets like US high-yield have remained generally well behaved. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during Q3/2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. We anticipate that bond investor uncertainty will switch from concerns about global growth to worries that stubbornly elevated inflation will elicit bond-bearish monetary policy responses from central banks. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2021 Model Bond Portfolio Performance: Positive Returns In An Uncertain Environment Chart 1Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was +0.21%, slightly outperforming the custom benchmark index by +8bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +4bps of outperformance versus our custom benchmark index while the latter also outperformed by +4bps. Those small positive excess returns should be considered a victory, given the huge yield swings within the quarter, particularly for government bonds. We maintained a significant underweight position to US Treasuries in the portfolio during Q3, given our view that markets were underestimating the risks that the US economy would weather the summer Delta storm. As Treasury yields declined steadily during July and August, so did the relative performance of our model bond portfolio. The government bond portion of the portfolio was underperforming the benchmark by as much as -30bps before global bond yields bottomed out in early August. In the end, there was only a slight underperformance (-2bps) from the US Treasury portion of the portfolio during the quarter (Table 2). Table 2GFIS Model Bond Portfolio Q3/2021 Overall Return Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Our biggest government bond overweights have been concentrated in the euro area. There, the sum of active returns during Q3 from our government bond allocations was +3bps, although that came entirely from above-benchmark allocations to inflation-linked bonds in Germany, France and Italy. We did make one major shift in our government bond allocations during the quarter, and it was both timely and successful. We downgraded our recommended UK Gilt exposure to underweight on August 11.2 We observed that the Bank of England (BoE) was starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge was losing momentum. The BoE rhetoric has proven to be even more hawkish than we anticipated, hinting at a possible rate hike before the end of 2021, leading Gilts to be the worst performing government bond market in our model portfolio universe during the quarter. The result: our UK underweight contributed +4bps to the portfolio performance during the quarter. Turning to the credit side of the portfolio, the most successful positions were our overweight tilts on high-yield in the US (+3bps) and euro area (+1bps). All other exposures contributed little to returns, an unsurprising development given our neutral allocations to investment grade corporates in the US, UK and euro area, as well as for USD-denominated EM corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 3GFIS Model Bond Portfolio Q3/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Biggest Outperformers: Overweight UK Gilts with a maturity greater than 10-years (+4bps) Overweight Italian inflation-linked bonds (+2bps) Overweight US high-yield: Ba-rated (+2bps) and B-rated (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10-years (-2bps) Overweight Japanese Government Bonds in longer maturity buckets: 7-10 years (-1bps) and greater than 10-years (-1bps) Overweight UK inflation-linked bonds (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q3/2021 GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. As can be seen in the chart, the bars look very close to that ideal for Q3/2021. Among the markets that represent our overweights, the most notably positive returns came from all euro area government bonds (a combined +136bps) and euro area corporates (a combined +20bps from investment grade and high-yield). Returns within our recommended underweight positions were even more notable: UK Gilts (-302bps), New Zealand government bonds (-103bps), EM USD-denominated sovereigns (-85bps), and Canadian government bonds (-45bps). Bottom Line: Our model bond portfolio slightly outperformed its benchmark index in the third quarter of the year by +8bps – a moderately positive result coming equally from underweight positions in government bonds and overweight allocations to spread product. Future Drivers Of Portfolio Returns Chart 5Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by our below-benchmark overall duration tilt – focused on our underweight stance on US Treasuries – and our overweight stance on high-yield corporates. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). While our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, has peaked, the overall level of 10-year bond yields within the major developed markets remains well below levels implied by the Indicator (top panel). That is most clearly evident when looking at the large gap between deeply negative real bond yields and the still-elevated level of the global manufacturing PMI, which typically leads real yields by around six months (second panel). We continue to view this gap between real yields and growth as the biggest mispricing in global bond markets – one that will eventually be rectified by the incremental reduction in monetary accommodation that is signaled by our Global Central Bank Monitor (bottom panel). The combined message from our Central Bank Monitor, Duration Indicator and the manufacturing PMI is that global bond yields are still too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US, UK and Canada). We have the highest conviction on the US and UK underweights, with a curve-flattening bias for both markets relative to the rest of the major developed markets (Chart 6). The bond-friendly (and risk asset-friendly) impact of global quantitative easing programs is fading, on the margin, with the annual growth rate of central bank balance sheets having already slowed sharply (Chart 7). The pace of tapering, and any subsequent rate hikes, will differ by country and support our government bond country allocations in the model portfolio. Chart 6Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Chart 7The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun   Chart 8Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens We expect the Fed to taper its pace of bond purchases over the first half of 2022, setting up a first Fed rate hike late next year. The Bank of Canada and the BoE will be the other developed market central banks that will both end QE and lift rates before the Fed does the same. On the other hand, the ECB, Bank of Japan and the Reserve Bank of Australia will maintain a more relatively dovish stance in 2022, with very modest tapering (at worst) and no rate hikes. Turning to inflation-linked bonds, we are maintaining an overall neutral allocation given the competing forces of rising global inflation and rich valuations. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are Italy, France, Canada and Japan (Chart 8). On the back of this, we are maintaining our overweight allocations to inflation-linked bonds in the euro area and Japan in our model portfolio, while staying neutral on US TIPS. Chart 9Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Moving our attention to the credit side of our model portfolio, a moderate overweight stance on overall global corporates (focused on high-yield) versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets is flashing a warning sign for the future performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator (by about twelve months) of the annual excess returns of both global investment grade and high-yield corporates during the “QE Era” since the 2008 financial crisis (Chart 9). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond outperformance around February 2022, particularly for high-yield versus government bonds and investment grade (top two panels). At the same time, our preferred measure of the attractiveness of credit spreads - the historical percentile ranking of 12-month breakeven spreads – shows that lower-rated high-yield credit tiers in the US and euro area offer spreads that are relatively high versus their own history compared to other credit sectors in our model bond portfolio universe (Chart 10). Using this metric, investment grade corporate spreads look much more fully valued, particularly in the US. Chart 10Lower-Rated High-Yield & EM Sovereigns Offer Relatively Attractive Spreads GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Given sharply reduced default risks in the US and Europe, with strong nominal growth supporting corporate revenues alongside low borrowing rates, the fundamental backdrop for riskier high-yield corporates is still positive. Thus, we are maintaining our overweights to high-yield bonds in both the US and euro area, while sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce that exposure in the model portfolio sometime in early months of 2022, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that means about the future path for global monetary policy and risk asset performance. Within the euro area, we are maintaining overweights to Italian and Spanish government bonds given the likelihood that the monetary policy backdrop will remain supportive (Chart 11). We expect the ECB to be one of the most accommodative central banks within our model portfolio universe in 2022. At worst, the ECB could deliver a modest reduction of total asset purchases, but with no rate hikes. Chart 11A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit Chart 12EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering Finally, we are sticking with a cautious stance on emerging market (EM) spread product in our model bond portfolio. Slowing Chinese economic growth, a firming US dollar, rate hikes across EM in response to high inflation, and the coming turn in the Fed policy cycle are all headwinds to the relative performance of EM USD-denominated corporates and sovereigns (Chart 12). We are sticking with our overall modestly underweight stance on EM USD-denominated credit. However, rebounding global growth and some potential policy stimulus in China could prompt us to consider an upgrade in the coming months.   Summing it all up, our overall allocations and risks in our model portfolio leading into Q4/2021 look like this: An overall below-benchmark stance on global duration, equal to -0.75 years versus the custom index (Chart 13). A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 14). This overweight comes almost entirely from allocations to US and euro area high-yield corporates. The tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is relatively low at 55bps (Chart 15). This fits with our desire to maintain only a moderate level of absolute portfolio risk, while focusing exposures more on relative tilts between countries and credit sectors. Chart 13Overall Portfolio Duration: Stay Below Benchmark GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 14Overall Portfolio Allocation: Small Spread Product Overweight GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry” of 16bps (Chart 16).   Chart 15Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Chart 16Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts We now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare We see global growth momentum, the stickiness of supply-driven inflation pressures and the Fed monetary policy outlook as the three most important factors for fixed income markets over the next six months, thus our scenarios are defined along those lines. Base case Global growth rebounds from the dip seen during July and August as fears over the spread of the Delta variant subside. Unemployment rates across the developed economies continue to decline on the back of ongoing demand/supply imbalances in labor markets. China is a relative growth laggard, but this will trigger fresh macro stimulus measures (credit, monetary, perhaps fiscal) from policymakers concerned about missing growth targets. Global supply chain disruptions will remain stubbornly persistent, keeping upward pressure on realized inflation rates in most countries even as commodity price momentum cools a bit on a rate of change basis. Most developed market central banks will move to dial back pandemic monetary policy stimulus to varying degrees, most notably the Fed and the Bank of England. The Fed will begin tapering its asset purchases around the turn of the year, to be completed during Q4/2021 thus setting the stage for a Fed rate hike in December. In this scenario, we expect the US Treasury curve to see some initial mild bear-steepening alongside moderately wider longer-term TIPS breakevens, before entering a more typical cyclical bear-flattening as the Fed begins tapering and rate hike expectations get pulled forward. The net result over the next six months: the entire US Treasury curve shifts higher in roughly parallel fashion, with the 10-year reaching 1.70% by next March. The VIX drifts a bit lower from the current 21 to 18, the US dollar is flattish (faster global growth offsets more USD-favorable real yield differentials versus other developed markets), the Brent oil price goes up +5% on the back of stronger global demand, and the fed funds target rate is unchanged at 0-0.25%. Upside growth & inflation surprise Global growth accelerates amid sharply diminished COVID risks and rallying stock and credit markets that loosen financial conditions. Consumer & business confidence recover smartly, as do hiring and capex. Global inflation rates accelerate from current elevated levels, but less from supply squeezes and more from fundamental pressures and faster wage growth. China loosens macro policies, but developed market central banks shift in an even more hawkish direction. The Fed signals a rapid 2022 taper and a funds rate liftoff well before year-end. In this scenario, real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve shifts much higher than in our base case, led by the 5-year maturity with bear-flattening beyond that point. The 10-year US Treasury yield climbs to 1.90% by the end of Q1/2022. The VIX moves higher to 25, the US dollar falls -3% (faster global growth offsetting a relatively modest increase in US/non-US real yield differentials), the Brent oil price goes up +10% and the fed funds target range is unchanged at 0-0.25%. Downside growth & inflation surprise Global growth loses additional momentum as consumer and business confidence stay muted. Supply/demand mismatches in labor markets remain unresolved, leading to a slower pace of employment growth. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration implements a much smaller-than-expected US fiscal stimulus. Supply chain disruptions persist, keeping inflation elevated even as growth slows (stagflation). Developed market central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to slower growth. The Fed chooses a slower drawn-out taper with liftoff delayed to 2023. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds target range stays at 0-0.25%. The inputs into the scenario analysis are shown in Chart 17 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 18. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 17Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 18US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis     Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The model bond portfolio is expected to deliver a positive excess return over the next six months of +60bps in the base case scenario and +57bps in the optimistic growth scenario, but is projected to underperform by -26bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Research Global Fixed Income Strategy/ European Investment Strategy Weekly Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The fourth quarter will be volatile as China still poses a risk of overtightening policy and undermining the global recovery. US political risks are also elevated. A debt default is likely to be averted in the end. Fiscal stimulus could be excessive. There is a 65% chance that taxes will rise in the New Year. A crisis over Iran’s nuclear program is imminent. Oil supply disruptions are likely. A return to diplomacy is still possible but red lines need to be underscored. European political risks are comparatively low, although they cannot go much lower, Russia still poses threats to its neighbors, and China’s economic wobbles will weigh on European assets. Our views still support Mexican equities and EU industrials over the long run but we are booking some gains in the face of higher volatility. Feature Our annual theme for 2021 was “No Return To Normalcy” and events have borne this out. The pandemic has continued to disrupt life while geopolitics has not reverted to pre-Trump norms. Going forward, the pandemic may subside but the geopolitical backdrop will be disruptive. This is primarily due to Chinese policy, unfinished business with Iran, and the struggle among various nations to remain stable in the aftermath of the pandemic. Chart 1Delta Recedes With Vaccinations Delta Recedes With Vaccinations Delta Recedes With Vaccinations Chart 2Global Recovery Marches On Global Recovery Marches On Global Recovery Marches On Chart 3Global Labor Markets On The Mend Global Labor Markets On The Mend Global Labor Markets On The Mend The underlying driver of markets in the fourth quarter will be the fact that the COVID-19 pandemic is waning as vaccination campaigns make progress (Chart 1). New cases of the Delta variant have rolled over in numerous countries and in US states that are skeptical toward vaccines. Global growth will still face crosswinds. US growth rates are unlikely to be downgraded further while Europe’s growth has been upgraded. However, forecasters are likely to downgrade Chinese growth expectations in the face of the government’s regulatory onslaught against various sectors and property sector instability (Chart 2). Barring a Chinese policy mistake, the global composite PMI is likely to stabilize. Labor markets will continue healing (Chart 3). The tug of war between unemployment and inflation will continue to give way in favor of inflation, given that wage pressures will emerge, stimulus-fueled household demand will be strong, and supply shortages will persist. Central banks will try to normalize policy but will not move aggressively in the face of any new setbacks to the recovery. Will China Spoil The Recovery? Maybe. Chinese policy and structural imbalances pose the greatest threat to the global economic recovery both in the short and the long run. The immediate risk to the recovery is clear from our market-based Chinese growth indicator, which has not yet bottomed (Chart 4). The historic confluence of domestic political and geopolitical risks in China is our key view for the year. China is attempting to make the economic transition that other East Asian states have made – away from the “miracle” manufacturing phase of growth toward something more sustainable. But there are two important differences: China is making its political and economic system less open and free (the opposite of Taiwan and South Korea) and it is confronting rather than befriending the United States. The Xi administration is focused on consolidating power ahead of the twentieth national party congress in fall 2022. Xi is attempting to stay in power beyond the ten-year limit that was in place when he took office. On one hand he is presenting a slate of socioeconomic reforms – dubbed “common prosperity” – to curry popular favor. This agenda represents a tilt from capitalism toward socialism within the context of the Communist Party’s overarching idea of socialism with Chinese characteristics. On the other hand, Xi is cracking down on the private sector – Big Tech, property developers – which theoretically provides the base of power for any political opposition. The crackdowns have caused Chinese equities to collapse relative to global and have reaffirmed the long trend of underperformance of cyclical sectors relative to defensives within Chinese investable shares (Chart 5, top panel). Chart 4China Threatens To Spoil The Party China Threatens To Spoil The Party China Threatens To Spoil The Party In terms of financial distress, so far only high-yield corporate bonds have seen spreads explode, not investment grade. But current policies force property developers to liquidate their holdings, pay off debts, and raise cash while forcing banks to cut bank on loans to property developers and homebuyers. (Not to mention curbs on carbon emissions and other policies squeezing industrial and other sectors.) Chart 5Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot If these policies are not relaxed then property developers will continue to struggle, property prices will fall, credit tightening will intensify, and local governments will be starved of revenue and forced to cut back on their own spending. Yet the government’s signals of policy easing are so far gradual and behind the curve. If policy is not relaxed, then onshore equities will sell off (as well as offshore) and credit spreads will widen more generally (Chart 5, bottom panel). Broad financial turmoil cannot be ruled out in the fourth quarter. Ultimately, however, China will be forced to do whatever it takes to try to secure the post-pandemic recovery. Otherwise it will instigate a socioeconomic crisis ahead of the all-important political reshuffle in fall 2022. That would be the opposite of what Xi Jinping needs as he tries to consolidate power. Chinese households have stored their wealth, built up over decades of economic success, in the housing sector (Chart 6). Economic instability could translate to political instability. Chart 6Beijing Will Provide Bailouts And Stimulus … Or Face Political Instability Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Investors often ask how the government can ease policy if doing so will further inflate housing prices, which hurts the middle class and is the opposite of the common prosperity agenda. High housing prices are the biggest of the three “mountains” that are said to be crushing the common folks and weighing on Chinese birthrates and fertility (the other two are high education and medical costs). The answer is that while policymakers want to cap housing prices and encourage fertility, they must prevent a general collapse in prices and economic and financial crisis. There is no evidence that suppressing housing prices will increase fertility or birthrates – if anything, falling fertility is hard to reverse and goes hand in hand with falling prices. Rather, evidence from the US, Japan, South Korea, Thailand, and other countries shows that a bursting property bubble certainly does not increase fertility or birthrates (Charts 7A and 7B). Chart 7AEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Chart 7BEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Bringing it all together, investors should not play down negative news and financial instability emerging from China. There are no checks and balances on autocrats. Our China Investment Strategy has a high conviction view that policy stimulus is not forthcoming and regulatory curbs will not be eased. The implication is that China’s government could make major policy mistakes and trigger financial instability in the near term before changing its mind to try to preserve overall stability. At that point it could be too late. Will Countries Add More Stimulus? Yes. Chart 8Global Monetary Policy Challenges Global Monetary Policy Challenges Global Monetary Policy Challenges With China’s stability in question, investors face a range of crosswinds. Central banks are struggling with a surge in inflation driven by stimulus-fueled demand and supply bottlenecks. The global output gap is still large but rapid economic normalization will push inflation up further if kinks are not removed (Chart 8). A moderating factor in this regard is that budget deficits are contracting in 2022 and coming years – fiscal policy will shift from thrust to drag (Chart 9). However, the fiscal drag is probably overstated as governments are also likely to increase deficit spending on the margin. The US is certainly likely to do so. But before considering US fiscal policy we must address the immediate question: whether the US will default on national debt. Treasury Secretary Janet Yellen has designated October 18 as the “X-date” at which the Treasury will run out of extraordinary measures to make debt payments if Congress does not raise the statutory debt ceiling. There is presumably a few weeks of leeway after this date but markets will grow very jittery and credit rating agencies will start to downgrade the United States, as Standard & Poor’s did in 2011. Chart 9Global Fiscal Drag Rears Its Head Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Democrats have full control of Congress and can therefore suspend the debt ceiling through a party-line vote. They can do this through regular legislation, if Republicans avoid raising a filibuster, though that requires Democrats to make concessions in a back-room deal with Republicans. Or they can compromise the filibuster, though that requires convincing moderate Democrats who support the filibuster that they need to make an exception to preserve the faith and credit of the US. Or they can raise the debt ceiling via budget reconciliation, though this would run up against the time limit and so far Senate Leader Chuck Schumer claims to refuse this option. While the odds of a debt default are not zero, the Democrats have the power to avoid it and will also suffer the most in public opinion if it occurs. Therefore the debt limit will likely be suspended at the last minute in late October or early November. Investors should expect volatility but should view it as short-term noise and buy on dips – i.e. the opposite of any volatility that stems from Chinese financial turmoil. Congress is likely to pass Biden’s $550 billion bipartisan infrastructure bill (80% subjective odds). It is also likely to pass a partisan social welfare reconciliation bill over the coming months (65% subjective odds). The full impact on the deficit of both bills should range from $1.1-$1.6 trillion over ten years. This will not be enough to prevent the fiscal drag in 2022 but it will provide for a gradually expanding budget deficit over the course of the decade (Chart 10). Chart 10New Fiscal Stimulus Will Reduce Fiscal Drag On Margin Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! The reconciliation package will be watered down and late in coming. Investors will likely buy the rumor and sell the news. If reconciliation fails, markets may cheer, as it will also include tax hikes and pose the risk of pushing up inflation and hastening Fed rate hikes. Elsewhere governments are also providing “soft budgets.” The German election results confirmed our forecast that the government will change to left-wing leadership that will be able to boost domestic investment but not raise taxes. This is due to the inclusion of at least one right-leaning party, most likely the Free Democrats. Fiscal deficits will go up. Germany has a national policy consensus on most matters of importance and thus can pass some legislation. But the new coalition will be ideologically split and barely have a majority in the Bundestag, so controversial or sweeping legislation will be unlikely. This outcome is positive for German markets and the euro. Looking at popular opinion toward western leaders and their ruling coalitions since the outbreak of COVID-19, the takeaway is that the Europeans have the strongest political capital (Chart 11). Governments are either supported by leadership changes (Italy, Germany) or likely to be supported in upcoming elections (France). The UK does not face an election until 2024, unless an early election is called. This seems doubtful to us given the government’s strong majority. Chart 11DM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Chart 12EM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! After all, Canada called an early election and it became a much riskier affair than the government intended and did not increase the prime minister’s political capital. Spain is far more likely to see tumult and an early election. Japan’s election in November will not bring any surprises: as we have written, Kishidanomics will be Abenomics by a different name. The implication is that after November, most developed markets will be politically recapitalized and fiscal policy will continue to be accommodative across the board. In emerging markets, popular opinion has been much more damning for leaders, calling attention to our expectation that the aftershocks of the global pandemic will come in the form of social and political instability (Chart 12). Russia has a record of pursuing more aggressive foreign policy to distract from its domestic ills. The next conflict could already be emerging, with allegations that it is deliberately pushing up natural gas prices in Europe to try to force the new German government to certify and operate the NordStream II pipeline. The Americans are already brandishing new sanctions. Chart 13Stary Neutral Dollar For Now Stary Neutral Dollar For Now Stary Neutral Dollar For Now Brazil and Turkey both face extreme social instability in the lead-up to elections in 2022 and 2023. India has been the chief beneficiary of today’s climate but it also faces an increase in political and geopolitical risk due to looming state elections and its increasing alliance with the West against China. Putting it all together, the US is likely to stimulate further and pump up inflation expectations. Europe is politically stable but Russia disrupt it. Other emerging markets, including China, will struggle with economic, political, and social instability. This is an environment in which the US dollar will remain relatively firm and the renminbi will depreciate – with negative effects on EM currencies more broadly (Chart 13). Annual Views On Track Our three key views for 2021 are so far on track but face major tests in the fourth quarter: 1. China’s internal and external headwinds: If China overtightens policy and short-circuits the global economic recovery, then its domestic political risks will have exceeded even our own pessimistic expectations. We expect China to ease fiscal policy and do at least the minimum to secure the recovery. Investors should be neutral on risky assets until China provides clearer signals that it will not overtighten policy (Chart 14). 2. Iran is the crux of the US pivot to Asia: A crisis over Iran is imminent since Biden did not restore the 2015 nuclear deal promptly upon taking office. Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Brent crude oil prices will see upside risks relative both to BCA forecasts and the forward curve (Chart 15). Chart 14Wait For China To Relax Policy Wait For China To Relax Policy Wait For China To Relax Policy Chart 15Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran The reason is that Iran is expected to reach nuclear “breakout” capability by November or December (i.e. obtain enough highly enriched uranium to make a nuclear device). The Biden administration is focused on diplomacy and so far hesitant to impose a credible threat of war to halt Iranian advances. Israel’s new government has belatedly admitted that it would be a good thing for the US and Iran to rejoin the 2015 nuclear deal – if not, it supports a global coalition to impose sanctions, and finally a military option as a last resort. Biden will struggle to put together a global coalition as effective as Obama did, given worse relations with China and Russia. The US and Israel are highly likely to continue using sabotage and cyberattacks to slow Iran’s nuclear and missile progress. Chart 16Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Chart 17Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Thus the Iranians are likely to reach breakout capability at which point a crisis could erupt. The market is not priced for the next Middle East crisis (Chart 16). Incidentally, any additional foreign policy humiliation on top of Afghanistan could undermine the Biden administration more broadly, in both domestic and foreign policy. 3. Europe benefits most from a post-pandemic, post-Trump world: Europe is a cyclical economy and is also relatively politically stable in a world of structurally rising policy uncertainty and geopolitical risk. We thought it stood to benefit most from the global recovery and the passing of the Trump administration. However, China’s policy tightening has undermined European assets and will continue to do so. Therefore this view is largely contingent on the first view (Chart 17). Investment Takeaways Strategically we maintain a diversified portfolio of trades based on critical geopolitical themes: long gold, short China/Taiwan, long developed markets, long aerospace/defense, long rare earths, and long value over growth stocks. Taiwanese equities have continued to outperform despite bubbling geopolitical tensions. We maintain our view that Taiwan is overpriced and vulnerable to long-term semiconductor diversification as well as US-China conflict. Our rare earths basket, which focuses on miners outside China, has been volatile and stands to suffer if China’s growth decelerates. But global industrial, energy, and defense policy will continue to support rare earths and metals prices. Russian tensions with the West have been manageable over the course of the year and emerging European stocks have outperformed developed European peers, contrary to our recommendation. However, fundamental conflicts remain unresolved and the dispute over the recently completed Nord Stream II pipeline to Germany could still deal negative surprises. We will reassess this recommendation in a future report. We are booking gains on the following trades: long Mexico (8%), long aerospace and defense in absolute terms (4%), long EU industrials relative to global (4%), and long Italian BTPs relative to bunds (0.2%).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Appendix: Geopolitical Calendar