Euro Area

Highlights Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 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. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks 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. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses Q2/2021 Performance: Credit Gains & Duration Losses Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. 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 Q2/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. 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 Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks 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. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. 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). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain 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 and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Cyclical Indicators Suggest Global Yields Still Have More Upside Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities UST Underperformance Will Shift To Shorter Maturities UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Longer-Maturity USTs Working Off Oversold Condition Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE A Sharply Diminished Impulse From Global QE A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. 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 in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Fading Support For Credit Markets From Global QE Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the 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 of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade Favor Italian BTPs Over Euro Area Investment Grade Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Major EM Risks: China Tightening & Global QE Tapering Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading EM Supportive USD Weakness Is Fading EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Chart 18Overall 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 After making the shifts to our model bond portfolio allocations in the US and EM, 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. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. 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 modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. 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 in a risk-off move, 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 rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. 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). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. 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. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Barring major surprises, President Macron will be re-elected in 2022. Any dramatic reversal in the pandemic that leads to a new recession would benefit the opposition candidate. Otherwise, Macron will remain the frontrunner. A second term for President Macron would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. This is bullish for France. Reducing the size of the state will go a long way to improve France’s economic competitiveness over the long run. Tactically, favor the more defensive Spanish market over the highly cyclical French market. Underweight French consumer discretionary equities relative to their European and global peers. Longer term, overweight French industrials equities relative to German ones, and overweight French tech equities relative to European ones. Ahead of the election, buy the dip on any euro weakness and French OAT/German bund spread widening. Feature The French presidential election is nine months away, and it is already starting to catch investors’ attention as one of the main political events in Europe in 2022. In talks with clients, we’ve been asked repeatedly about the odds we assign to a Marine Le Pen victory and the market implications. Those concerns are understandable but overrated. Le Pen’s personal approval rating is on the rise, and, in most polls, the far-right candidate beats President Emmanuel Macron in the first round vote, although not the critical second round. Although the same polls see Macron being re-elected, the gap between the two has narrowed considerably since the 2017 election, which Macron won by 66 percent of the vote.   Still, Macron is favored for re-election. He has several strong advantages over Le Pen, and it is unlikely she will be able to close the gap further before the election. Macron’s first term has been eventful. Neoliberal structural reforms started with drums beating in the first 18 months of his term. But the pace and breadth of reform eventually became too ambitious or painful for France to bear, and protests erupted in 2018. First came the “Yellow Vest Movement,” and then came protests against pension reform. Macron tried to compromise and continue with his agenda, but COVID-19 forced his hand. Since then, Macron has focused on crisis management, benefiting from the large state sector’s role as an automatic stabilizer amid the downturn. A second term under President Macron would see a reboot of the structural reforms started in 2017, albeit without single-party rule in the National Assembly. Reforms aimed at reducing the size of the state, and its cost, would go a long way to improve France’s economic competitiveness over the long run. Therefore, the prospect of Macron’s reelection is bullish for France, even though the reality of his second term would be more complex. 2017 All Over Again? Yes And No At first glance, the 2022 election seems to be a repeat of 2017. Le Pen and Macron are likely to face off in the second round and the latter, the Europhile centrist candidate, is likely to win once more. However, everything surrounding this election has changed. The Incumbency Effect One of the major changes is favorable for Macron: he is the incumbent running for re-election. Macron had been part of President Francois Hollande’s government since 2014, so he was still viewed in 2017 as a political neophyte and dark horse candidate. His rapid rise to power, along with that of his upstart party, La République En Marche (LREM), was astounding. Chart 1Pro-Incumbency Effect Favors Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu There is a strong pro-incumbency effect in French presidential elections, especially in the first round (Chart 1). Since 1965, five incumbents have run for re-election, and all have made it to the second round. Importantly, four won first place in the first round, with a six percentage-point margin on average. The chief exception is Nicolas Sarkozy in 2012. The reason for Sarkozy’s loss, however, is well known: he attempted to pass an unpopular pension reform in the teeth of the Euro debt crisis, 12 months before facing re-election. The only other incumbent who failed at re-election was Valerie Giscard d’Estaing, who lost to Francois Mitterrand in 1981, when the whole world was in stagflation and upheaval. The incumbency effect is not as pronounced in the second round (Chart 1, bottom panel). However, when facing a far-right candidate, incumbents win by a wide margin. This was the case in 2002 and 2017. Today, Macron still has a 12-point lead on Le Pen. Macron compares well to his predecessors. Chart 2 shows the approval rating for all presidents sitting in office over the past 40 years. The number of people who intend to vote for Macron has increased, the first time this has happened for an incumbent president since 1988. Only three presidents had a higher approval rating at this stage of their term, albeit from a higher starting point. Macron’s approval rating has increased by 10% since February 2020, when the COVID-19 pandemic hit Europe. Chart 2Macron Compares Well To His Predecessors France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Table 1Incumbency And Recessions Under The Fifth Republic France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu The shock of the pandemic and recession is the greatest change since 2017, and the biggest challenge facing Macron. Four incumbents have made a bid for re-election that was preceded by a recession within 12-24 months (Table 1). The results are mixed, and it is hard to establish a clear anti-incumbency effect. If anything, the timing and nature of this crisis are likely to help Macron rather than hurt him, since the vaccination campaign and easing of lockdown measures will enable the economy to normalize and improve ahead of April 10-24, 2022, when voters cast their first ballots. Nonetheless, another major shock (of any kind) could undermine the incumbent advantage. Economic Recovery Is The Top Priority While the Macron administration’s handling of the pandemic was questioned, public opinion was never aggressively hostile toward his handling of the economy. Macron was instrumental in securing a major European fiscal stimulus package (and joint debt issuance) with the German Chancellor, Angela Merkel. He enthusiastically adopted the crisis mentality of “whatever it takes” to wage war against COVID-19, enabling the oversized French state to deploy the most generous furlough scheme in Europe, shielding millions of workers and preventing businesses from going under. This will be one of his winning cards. Chart 3The Handling Of The Pandemic Dictates Macron's Popularity The Handling Of The Pandemic Dictates Macron's Popularity The Handling Of The Pandemic Dictates Macron's Popularity His approval rating began to rebound following the end of lockdowns (Chart 3). This trend should strengthen as the French economy reopens, supported by a government that will play an accommodative and reflationary economic role until the election. Public opinion wants him to focus on the labor market and the economic recovery in the months to come, and he will be happy to oblige. Public opinion also views Macron as the most qualified candidate when it comes to economic matters (Table 2). 42% of respondents think that Le Pen is not qualified “at all” on economic matters, her Achilles’ heel, a perception that was already entrenched when Macron crushed her in a televised debate before the second round of the 2017 election. Table 2Macron Is Perceived As The Most Qualified To Oversee The Economic Recovery France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Europhile Versus Eurosceptic? The central issue of the 2017 election was Europe and France’s role in it. Following the UK’s disruptive Brexit referendum in 2016, and a long tradition of Euroscepticism within her party, Le Pen campaigned on “Frexit” and the abandonment of the euro. Conversely, Macron embraced the EU and the monetary union as he ran for president and committed to having France play a more important role within the bloc if he won. Chart 4Le Pen And The EU: Not The Divorce We Expected Le Pen And The EU: Not The Divorce We Expected Le Pen And The EU: Not The Divorce We Expected Since then, Le Pen has drastically shifted her stance on the EU. She now claims that the benefits of the common currency and single market outweigh the costs. After all, 70% of the French public support the euro and EU membership (Chart 4). Like clockwork, her personal approval ratings have steadily gone up. This strategic shift aligns her with the median voter, and combined with the Covid crisis, it is the only reason to take her candidacy remotely seriously in 2022, despite Macron’s clear advantages. Nevertheless, Le Pen has not yet risen above her 2012 peak in popular support. She failed to do so between 2014 and 2015, when the lingering European debt crisis, the Syrian refugee crisis, multiple terrorist attacks in France, and sluggish economic growth should have boosted her popularity. Her shifting perspective on the euro was therefore necessary and might be just what she needs to break through her 37% ceiling of popular support. Le Pen’s policy agenda is now focusing on protectionism, immigration, and national security. It is a Trumpian mix. However, while her new stance is more mainstream, it also differentiates her less from the other center-right politicians in France, namely Xavier Bertrand, who recently made local electoral gains in Le Pen’s northern industrial base. Macron is as strong an advocate for Europe as ever. He convinced Germany to break the taboo on joint fiscal policy during the pandemic. Now, he is also mounting a bid to become the natural leader of Europe, given that Merkel is stepping down, and her party is likely to lose standing in the German election in September.  France is set to take over the rotating EU Council Presidency in the first half of 2022, under the theme “Recovery, power, belonging,” which provides Macron with a golden opportunity to pitch himself as Europe’s premier statesman and economic steward in the final months of the election campaign. One Thing Hasn’t Changed: The Outcome Of A Macron/Le Pen Duel Most opinion polls give Macron a 10-12 point lead on Le Pen in the second round of the election. This gap is wide enough to reassure investors that it is not a polling error. However, in 2017, Macron’s average lead over Le Pen was 22%, and he won the election with 66% of votes. It is the narrowing of that gap that raises eyebrows among investors. Table 3Ideological Blocs Also Favor Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Still, Le Pen’s chances at closing the gap are overrated. She is not a political “unknown” anymore and has very little ability to “surprise” voters into rallying around her next year. She will have trouble persuading those who know all about her. Grouping French voters according to ideological blocs, that is, presidential preference by party affiliation, suggests that the biggest threat to Macron is a strong center-right candidate who can beat Le Pen, especially if this should coincide with a revival of the center-left (Table 3). Otherwise, as in 2017, Macron will be able to count on voters from other parties in the second round of the election (Table 4). While both candidates appeal to right-wing constituents and would have to share their ballots, Macron can count on the green EELV party, as well as left-wing voters, to join center-right voters to elect him. Macron has made environmental issues a part of his mandate, which should help him confront a green neophyte such as Le Pen. Table 4Voting Against Le Pen Implies Voting For Macron France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu The results of the regional elections held last month confirm this analysis. The motivation to keep Le Pen and her Rassemblement National (National Rally) party out of power is still strong (see Box 1). The poor showing of the National Rally means she won’t be able to maintain her current momentum in her personal approval ratings.   Box 1 2021 Regional Elections: Bad Omen For Marine Le Pen In Revival Of The Center-Right? The regional elections took place on June 20 and 27. While limited in relevance for the 2022 presidential race, the result of extremely low voter turnout, regional elections offer a gauge of how constituents feel about the political offerings from anti-establishment parties. Le Pen’s party suffered a heavy blow. It had hoped to consolidate power and build momentum ahead of the presidential election, but it failed even to win in its stronghold of Southern France. Meanwhile, Macron’s party (La République En Marche!) also disappointed. This outcome is not surprising; the local elections last year yielded similar results, highlighting the lack of presence at the local and regional levels for the four-year-old party. The surprise came from the center-right. It managed to win seven of the thirteen regions, beating far-right candidates by wide margins. Importantly, Xavier Bertand, Valérie Pécresse, and Laurent Wauquiez, all predicted to run for president next year, held onto their seats.   Chart 5Strong Demographic Base In The Second Round France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Both candidates’ demographic bases have remained the same. Macron is still popular among Millennials, white collar workers, and the elderly (Chart 5). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, and he still outperforms Le Pen among rural voters in today’s polls. Macron also scores high among the employees of the public sector—even though he is in favor of a smaller public sector. Furthermore, the unemployed mostly favor him, which reinforces the perception that he is the best candidate to improve the French economy and cut the unemployment rate. What if Le Pen fails to make it into the second round of the election? We discuss this possibility in the next section. Risks To The Base Case Scenario The greatest risks to our view are a setback in the economic recovery, an outperformance from the center-right, and the emergence of a dark horse. The latest developments in the UK and Israel, where a large share of the population is fully vaccinated, suggest that the “Delta” variant of COVID-19 remains a threat, with the potential to send economies back into lockdowns. The consequences would be dire for Macron. His chances at re-election would likely evaporate if his government imposed new lockdown measures. What about presidential candidates other than Le Pen? Our base case scenario that Macron will win is based on two assumptions: (1) the center-left Socialist Party will remain in shambles, and (2) the center-right remains scattered under different banners and will therefore lack unity. There is very little chance that the center-left will make a comeback in time, but the results from the regional elections suggest that the center-right could surprise to the upside (see Box 1), especially if it decides to rally behind a single candidate ahead of the first round. Could this candidate be a dark horse? Former Prime Minister Edouard Philippe or outsider candidate Xavier Bertrand could make formidable opponents to both Macron and Le Pen. Philippe’s personal approval rating currently stands at 50%, the highest among French politicians. He also appeals to constituents of all political leanings (Chart 6). This scenario could reshuffle the likely outcomes of both the first and second round of the election. Both Bertand and Philippe could win over voters who decided to side with Le Pen in 2017, while Philippe can compete with Macron over LREM voters. Additionally, Xavier Bertrand cuts into Le Pen’s support since he has made blue collar workers and the middle-class a priority. However, Macron and Le Pen each enjoy a strong voters’ base. It is necessary to monitor whether Valérie Pécresse (Soyons libres) and Laurent Wauquiez (Les Républicains) can be brought to endorse Xavier Bertrand ahead of the first round in 2022. Chart 6Edouard Philippe: From Ally To Outcast To Challenger? France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Beyond The Election Aside from the presidency, the outstanding question is the makeup of the National Assembly in 2022. Macron is not likely to enjoy the strong single-party legislative majority of his first term or to gain control of the Senate. Consequently, he will be more constrained in the legislature in a second term. Nonetheless, the demand for a better economy and a healthier job market requires pro-productivity reforms, which the public knows, and Macron has made reform his banner. Other conventional parties will come under pressure to support Macron’s reform agenda, even though that agenda will be less ambitious than it was in his first term. Chart 7Strong Presence Of Right-Leaning Forces Strong Presence Of Right-Leaning Forces Strong Presence Of Right-Leaning Forces Efforts at cutting back the size of the state are still likely, even though the pandemic has helped rather than hurt statism. This is because the French median voter, who never witnessed the degree of neoliberal reform that took place in the Anglo-Saxon world, has grown weary of the economy’s inefficiencies, just as the Anglo-Saxons have grown weary of laissez-faire neoliberalism. Before the pandemic, the French people understood the need to reduce the size of the state. After all, a larger state implies a larger cost burden borne by both households and corporations. When faced with the choice between paying the bill for the government’s fiscal response to COVID-19 (through higher taxes), or undertaking reforms aiming at reducing the size of the state, the French people will pick the former. Moreover, centrist forces will hold sway in the legislature (Chart 7); hence, some kind of budget normalization is expected in 2023 or thereafter. Other structural reforms If Macron wins would include pension reforms. We should also expect measures to push French companies to bring activities back to France, as well as a greater focus on leading France on the green path. Bottom Line: Barring major surprises, President Macron will be re-elected in 2022. There is a risk to our view if a center-right candidate defeats Le Pen to make it to the second round of the election. Either Macron or a center-right presidency would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. Investment Implications The French economy is currently experiencing an economic upswing. Three factors explain this pick-up: ultra-accommodative monetary conditions in Europe, fiscal largesse, and considerable pent-up demand. In 2021, GDP is projected to expand by 5.75% in annual average terms, higher than the Euro Area average of 4.6%. It should then grow by 4% in 2022 and by 2% in 2023. We remain bullish on French equities on a secular basis, as long as the elections result in further incremental structural reforms over time. As the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip. French Equities The CAC40 and French equities have had a good run since the beginning of the year. In absolute terms, the CAC40 is one of the best performers year-to-date, up +17%, driven by the outperformance of French consumer discretionary and financials equities, both in absolute and relative terms. However, a period of turbulence is appearing on the horizon; the shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries are creating headwinds for the cyclicals-to-defensives ratio this summer. As such, we recently recommended investors downgrade cyclical equities tactically in Europe from overweight to neutral. With 66% in cyclicals, the French MSCI equity index will underperform in this environment, especially relative to the more defensive Spanish market (Table 5). Table 5Cyclicals Versus Defensives In European Markets France: More Than Just A Déjà-Vu France: More Than Just A Déjà-Vu Chart 8Three Trade Ideas Three Trade Ideas Three Trade Ideas In fact, our Combined Mechanical Valuation Indicator (CMVI) shows that French consumer discretionary equities are expensive relative to both their European and global peers (Chart 8). Regarding the reform theme, we stick with our long French industrial equities / short German industrial equities on a long-term horizon (Chart 8, second and third panel). The idea is that French reforms should suppress unit labor costs and make French exports more competitive vis-à-vis their main competitor, Germany. The latter faces a leftward shift in policy in elections this September. Finally, we recommend investors go long French tech stocks relative to their European counterparts. This sector is cheap (Chart 8, bottom panel), and the French tech sector will be supported by additional government spending of EUR7 billion on digital investments over the next two years. Bond Markets & FX A dovish ECB is consistent with a continued overweight in European peripheral bonds and an underweight stance on French government bonds. Chart 9Just Buy The Dip Just Buy The Dip Just Buy The Dip What is more relevant with respect to the French election is the OAT/Bund spread. In the past, unusually wide spreads between the two represented a euro breakup premium. In early 2017, spreads widened when the approval rating of Le Pen increased (Chart 9). However, since “Frexit” and the abandonment of the euro are no longer part of Le Pen’s agenda, investors should view spread widening as a buying opportunity. Similarly, investors should buy the euro on any election-related dip, particularly following the first round. “Frexit” has been removed from the equation, hence the euro should not weaken on breakup risk this time around. Bottom Line: We remain bullish on French equities within a European portfolio on a secular basis. If our views on the cyclicals-to-defensives ratio materialize in the near-term, highly cyclical French equities will temporarily underperform, unlike the more defensive Spanish market. On a 3- to 12-month horizon, investors should short French consumer discretionary equities relative to both their European and global counterparts. Current valuations suggest that betting on the booming French tech sector at the expense of its European neighbors will be profitable. Once the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com

This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the first quarter of 2021 point towards easing standards in developed markets (Chart 1). Credit standards for business loans eased outright in most regions except for the euro area and New Zealand where the pace of tightening slowed significantly. On the whole, banks expected the easing trend to continue into Q2. Chart 1Credit Standards Moving Towards Or Deeper Into Easy Territory Credit Standards Moving Towards Or Deeper Into Easy Territory Credit Standards Moving Towards Or Deeper Into Easy Territory With credit spreads at historical tights, banks across the board cited increased competition from other lenders as a reason behind easing standards, confirming that easy financial conditions are not limited solely to booming financial markets. This will help maintain a market-friendly economic growth backdrop as developed economies put pandemic restrictions behind them. At the same time, an absence of tightening lending standards by commercial banks puts incremental pressure on central banks to move towards bond-bearish tightenings of monetary policy. An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and, thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As loan officers have access to detailed, non-public information on a large number of borrowers, they are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q1/2021 (Chart 3). Nearly 20% of respondents cited an improving or less uncertain economic outlook as a very important factor behind the decision to ease standards, while roughly one-third cited increased competition from other lenders. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions Chart 4High-yield Borrowers Are Exposed To A Widening In Spreads High-yield Borrowers Are Exposed To A Widening In Spreads High-yield Borrowers Are Exposed To A Widening In Spreads Although it did not strengthen on net, C&I loan demand did weaken at a much slower pace in Q1. The factors driving loan demand suggest a buoyant economic backdrop—about a quarter of banks reporting increased demand cited merger and acquisition needs and increased investment as very important reasons. Meanwhile, weaker loan demand was attributed to less precautionary demand for cash and an increase in internally generated funds among customers. On the consumer side, loan demand improved slightly on the whole, driven largely by a significant improvement in auto loan demand. While consumer loan demand has historically correlated well with the year-over-year growth in personal consumption expenditures, those two series diverged remarkably in Q1, with spending growth far outpacing loan growth. This divergence reflects the tremendous impact of pandemic-related transfer payments and benefits. We expect a continued recovery in consumer lending demand as unemployment benefits are withdrawn and consumers once again have to borrow to finance spending. As part of the special ad-hoc questions in this edition of the survey, respondents were asked about how lending standards had changed compared to the pre-pandemic period by borrower risk rating. Interestingly, large banks actually eased their standards for investment grade borrowers, reflecting the impact of Fed’s massive liquidity injections (Chart 4). However, despite spreads on high-yield having tightened to post-GFC lows, credit standards for below-investment grade borrowers remain much tighter than before the pandemic. So far, lower-quality borrowers have been able to go to public debt markets for financing, but this highlights a downside risk—if there is an event which causes corporate bond spreads to widen, high-yield borrowers may be starved of cheap financing options with banks still holding purse strings taut. Euro Area In the euro area, banks continued to tighten standards to enterprises, albeit at a much-reduced pace, in Q1/2021 (Chart 5). The tightening, however, was lower than expected in the previous quarter, possibly reflecting prolonged policy support and improving risk sentiment. Deteriorating risk perceptions related to the general economic and firm-specific situation were the primary contributing factor to tightening. But this was partly offset by increased competition from other lenders. The reduced pace of tightening does confirm the signal from the high-yield default rate, which is rolling over. Going forward, banks expect the pace of tightening to slow very slightly going into Q2. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Business credit demand continued to weaken at a faster pace in Q1, marking three consecutive quarters of deterioration. Weak fixed investment continued to be the biggest drag on demand, while the previous positive contribution from inventory and working capital needs has disappeared entirely. As we highlighted in the last edition of this chartbook, the continued drag on demand for investment reflects a lingering uncertainty regarding the pandemic which could possibly lower potential long-term growth in the euro area.2 As in the US, however, the reduction in demand also reflected already built-up liquidity buffers and the availability of internal and market-based financing. In Q2, banks expect a strong rebound in enterprise loan demand, especially from small and medium-sized enterprises (SMEs). Consumer credit demand continued to decline at a stronger pace in Q1, reflecting the continued pandemic-related restrictions in Europe over the quarter. The key drivers were lower durable goods spending and weakening consumer confidence. Banks also reported increased use of internally-generated funds, which is consistent with accumulated savings and pent-up demand during the lockdown. Assuming that the emerging Delta variant does not sidetrack the European return to normalcy, we will likely see the expected consumer credit demand rebound come to fruition. This would be consistent with recent strong consumer confidence prints out of the region. Looking individually at the four major euro area economies, credit standards for enterprises tightened in Germany, Italy, and Spain but were unchanged in France (Chart 6). In countries where standards tightened, worsening risk perceptions were the primary factor. In France, increased competition from other lenders contributed to easing on the margin. Going into Q2, standards are expected to tighten very modestly in the two core European economies while diverging in peripheral Europe—Spanish banks expect an increased pace of tightening while Italian ones expect standards to remain unchanged. UK In the UK, overall corporate credit standards, measured as an average of standards for medium and large non-financial firms, eased slightly in Q1/2021 (Chart 7A). This increase in credit availability was driven primarily by an improving economic outlook and sector-specific risk picture. As in the US and euro area, competition from capital markets also played a role and is expected to contribute to the further easing expected in Q2. Chart 7AUK Credit Conditions UK Credit Conditions UK Credit Conditions Chart 7BInvestment And Inventory Financing Expected To Pick Up In The UK GFIS Credit Conditions Chartbook Q2/2021: Easing Up GFIS Credit Conditions Chartbook Q2/2021: Easing Up Meanwhile, corporate loan demand is picking up at a pace not seen since Brexit, excluding the 2020 spike driven by emergency funding needs, signaling a buoyant picture. In particular, the surge in demand was driven by large non-financial firms which are also expected to drive the demand pick-up in Q2. Household loan demand fell slightly in the first quarter but is expected to rebound. Consumer confidence, which had initially lagged behind loan demand, appears to have caught up as the UK’s “Freedom Day” from pandemic restrictions approaches in July. Lenders are also expected to ease availability for unsecured household loans, primarily on the back of market share objectives. This should create the ideal backdrop for a consumption boom if the Delta variant does not further limit the UK government’s ability to deliver on its promise of a full reopening. Delving into the factors behind booming corporate loan demand, there are promising signs for the broader UK economy (Chart 7B). In a Special Report published earlier this year, we argued that UK real interest rates were depressed because the country suffered from a series of rolling economic and political shocks, the effects of which were now expected to fade.3 There are already some signs of this in the credit data, with capital investment and inventory financing demand expected to rebound in Q2. Despite work-from-home effects dampening the need for office space, on the margin, UK commercial real estate demand is strong and expected to further strengthen. Japan Chart 8Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions In Japan, credit standards to firms and households eased at a slower pace in Q1/2021 (Chart 8). The vast majority of respondents indicated that standards were basically unchanged, with none of the firms reporting any tightening, and a small number reporting some degree of easing. The most important factors driving easing were aggressive competition from other bank and non-bank lenders, as well as strengthened efforts to grow the business. Going into Q2, the pace of easing is expected to continue to slow. Business loan demand, which behaves somewhat counter-cyclically in Japan, increased over Q1. The entirety of this pickup can be attributed to small firms; large and medium-sized firms on the whole decreased their loan demand. Counter to trends in other regions, firms in Japan actually saw a decrease in internally-generated funds, which was the most important factor contributing to increased loan demand. Consumer loan demand fell slightly on balance but was mostly unchanged from the previous quarter. Respondents reporting weaker demand saw a decrease in household consumption as the most important factor. Sentiment remains subdued and has lagged the recovery in loan demand seen last year. Our colleagues at BCA Research Foreign Exchange Strategy are eyeing a recovery for the Japanese economy as the government turns around its vaccination campaign and the Olympics jumpstart consumption.4 On that basis, the very modest recovery in loan demand expected by Japanese banks appears too pessimistic. Canada And New Zealand In Canada, business lending standards continued to ease at a faster pace in Q1/2021, coinciding with rebounding business confidence which is now back to pre-pandemic levels (Chart 9). This is in line with a remarkable vaccine rollout—68% of the population has already received its first dose and the pace of daily vaccinations is showing no signs of rolling over. Chart 9Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions Chart 10New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions However, housing is a major concern for Canadian policymakers. In a recent Special Report, co-authored with our colleagues at The Bank Credit Analyst, we highlighted both Canada and New Zealand as “higher risk” countries more exposed to ballooning house prices.5 In addition to low rates, mortgage lending standards, which have been easing since Q3/2020, have undoubtedly contributed to this issue. However, the Bank of Canada (BoC), with its hawkish messaging, has signaled that it will not idly stand by; there is also popular support behind raising rates to tamp down house prices. Expect mortgage standards to tighten and a pick-up in mortgage rates as the BoC nears liftoff, most likely in 2022. Credit standards in New Zealand were mostly unchanged in Q1/2021, reversing the tightening trend of previous quarters (Chart 10). Over the next six months, standards are expected to ease considerably. Business loan demand was unchanged on net, with corporates decreasing and SMEs increasing demand. SMEs are also expected to increase demand slightly over the next six months. Tepid loan demand is consistent with business confidence hovering around the neutral zero line. As in Canada, soaring house prices are a major issue for the New Zealand economy. Data on household lending is alarming on that front. Although consumer loan demand continued to weaken, demand for residential mortgages spiked to an all-time high in Q1. While demand is expected to normalize going forward, the Q1 datapoint indicates froth in the market. The Reserve Bank of New Zealand is considering a variety of macroprudential measures but will have to raise rates sooner rather than later to effectively cool down the housing market. Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q1 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery", dated February 16, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. 4 Please see BCA Research Foreign Exchange Strategy Report, "The Case For Japan", dated June 11, 2021, available at fes.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com.

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) Three Key Views On Track (So Far) Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals China's Communist Party Centenary Goals China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Iran's Oil Production Will Return Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 13BGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 17Go Long Large Caps And Defensives Go Long Large Caps And Defensives Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK 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 – Province Of China Taiwan Territory: GeoRisk Indicator Taiwan Territory: 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

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Global Policy Uncertainty Revives Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 10US Ends Trade War With Europe? Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk Russia's Domestic Political Risk Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Cyber Security Stocks Recover Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Long UK Versus Eastern Europe Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Long GBP Versus CZK Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 20Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 21BGerman Greens Still Underrated Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 23Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Mexico To Outperform Latin America Mexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America China's Slowdown Will Hit South America China's Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights Bond Market Performance: Government bonds in the developed economies are currently trapped in ranges, consolidating the sharp upward moves seen in the first quarter of 2021. This is only a pause in the broader cyclical uptrend, however, with central banks under increasing pressure to turn less dovish amid surging inflation and tightening labor markets. Oversold USTs: Technical indicators of yield/price momentum and investor sentiment/positioning suggest that US Treasuries are oversold. Working off this condition can take another 2-3 months, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation for Australian government bonds to overweight on a tactical (0-6 months) investment horizon. Feature Dear Client, Next week, in lieu of our regularly weekly report, I will be hosting a webcast on Tuesday, June 15 where I will discuss the outlook for global fixed income markets in the second half of 2021. Following that, we will be jointly publishing our bi-annual Global Central Bank Monitor Chartbook with our colleagues at BCA Research Foreign Exchange Strategy on Friday, June 18th. We will return to our regular publishing schedule on Tuesday, June 29th. Best Regards, Rob Robis Chart of the WeekA Tale Of Two Quarters A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields The performance of government bond markets in the developed world so far in 2021 has been a tale of two quarters. In Q1, yields were rising steadily on the back of upside surprises in global growth and emerging signs of the biggest inflation upturn seen in nearly a generation. The Bloomberg Barclays Global Treasury index delivered a total return of -2.7% (hedged into US dollars) during the quarter, with no country escaping losses (Chart of the Week). The biggest declines were seen in the UK (-7.5%) the US (-4.3%), with the smallest losses occurring in Japan (-0.3%) and Italy (-0.7%). Chart 2Lower Vol Means High Yielders Outperform Low Yielders Lower Vol Means High Yielders Outperform Low Yielders Lower Vol Means High Yielders Outperform Low Yielders Q2 has been a different story, however. Yields have retreated somewhat from the year-to-date peaks seen at the end of Q1, leading to positive returns so far in Q2 in the UK (+0.8), the US (+1.2%) and Australia (+1.1%). The laggards are the low yielding euro area markets, most notably Italy (-0.7%) and France (-0.9%), that have seen yields move higher on the back of accelerating European growth. The Q2 returns look very much like a carry-driven market, with higher-yielding markets outperforming lower-yielding ones. That trend can persist if the current backdrop of low market volatility persists (Chart 2), although this calm will eventually be broken by a shift towards less dovish monetary policies. Some countries will make that shift at a faster pace than others, leading to relative value opportunities for bond investors in the latter half of 2021. This week, we discuss one such opportunity – Australia versus the US. US Treasuries: Oversold & Trendless – For Now After reaching a 2021 intraday high of 1.77% back on March 30, the benchmark 10-year US Treasury yield has traded in a narrow 15bp range between 1.55% and 1.70%. From a fundamental perspective, US yields are lacking direction because inflation expectations have already made a major upward adjustment to the more inflationary backdrop, but real yields have remained depressed by the continued dovish messaging from the Fed – for now - with regards to the timing of tapering or future rate hikes. From a technical perspective, however, the sideways pattern for US Treasury yields is also consistent for a market that trying to work off an oversold condition. Most of the technical indicators for the US Treasury market that we monitor regularly were at or close to the most bearish/oversold extremes seen since 2000 (Chart 3): Chart 3US Treasuries Are Working Off An Oversold Condition US Treasuries Are Working Off An Oversold Condition US Treasuries Are Working Off An Oversold Condition The 10-year Treasury yield is 39bps above its 200-day moving average, but that gap was as high as 84bps on March 19; The 26-week total return of the 10-year Treasury is -4.7%, after reaching a low of -8.8% on March 19; The JP Morgan client survey of bond managers and traders shows some of the largest underweight duration positioning in the 19-year history of the series; The Market Vane index of sentiment for Treasuries is in the bottom half of the range that has prevailed since 2000; The CFTC data on positioning in 10-year Treasury futures is the only one of our indicators that is not signaling an oversold market, with a small net long position of +3% (scaled by open interest). The overall message of these indicators suggests that price momentum and positioning reached such a bearish extreme by mid-March that some pullback in Treasury yields was inevitable. However, a look back at past periods when Treasuries became heavily oversold since the turn of the century shows that the duration and magnitude of such a pullback is highly variable – anywhere from two months to ten months. The main determining factors are the trends in economic growth and inflation in the US, and the Fed’s expected policy response to both. To show this, we conducted a simple study, updating work we first presented in a 2018 report.1 We looked at “oversold episodes” since 2000, which began when the 10-year Treasury yield was trading at least 50bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield subsequently converged back to its 200-day moving average. We then looked at the length of the episode (in days), and the change in bond yields, for each oversold episode. There were nine such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we rank the episodes by the number of days it took to complete each one, based on our simple moving average rule. We also show the change in both the 10-year Treasury yield and its 200-day moving average during each episode, to show how the convergence between the two unfolds. Table 1A Look At Prior Episodes Of An Oversold Treasury Market A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields To describe the US economic backdrop during each episode, we looked at the change in the ISM manufacturing index and core PCE inflation during those oversold periods. We also show changes in two important determinants of the level of Treasury yields: inflation expectations using 10-year TIPS breakeven rates, and Fed rate hike expectations using our 12-month Fed discounter which measures the expected change in interest rates - one year ahead - priced into the US overnight index swap (OIS) curve. At the bottom of the table, we show the average for all nine oversold episodes, as well as the averages for the episodes were the ISM was rising and where core PCE inflation was rising. Chart 4US Treasury Market Oversold Episodes: 2003-2007 US Treasury Market Oversold Episodes: 2003-2007 US Treasury Market Oversold Episodes: 2003-2007 There are a few messages gleaned from the results in Table 1: The longest correction of an oversold Treasury market since 2000 took place between February 2018 and December 2018, when 305 days passed before the 10-year yield fell back to its 200-day moving average; The shortest correction was between June 2007 and August 2007, where only 52 days elapsed; Treasury yields typically decline during oversold periods, with two notable exceptions: 2018 and 2013/14, which were also the two longest episodes; During all of the oversold periods, markets reduced the amount of expected Fed tightening by an average of 26bps. However, that was entirely concentrated in four of the nine episodes - including three of the four shortest episodes – and is typically associated with a decline in inflation expectations. Growth momentum appears to be a bigger factor than inflation momentum in determining the length of an oversold episode, with longer episodes typically occurring alongside a rising ISM index, and vice versa. The notable exception was the longest episode in 2018, where the ISM declined by six points, although the bulk of that decline occurred in a single month at the end of the period (November 2018). For the more visually oriented, we present the time series for all the data in Table 1, shaded for the oversold periods, in Chart 4 (for the 2003-2007 period), Chart 5 (2008-2012), Chart 6 (2013-2017) and Chart 7 (2018 to today). We’ve added one additional variable – our Fed Monitor, designed to signal the need for tighter or looser US monetary policy – in the bottom panel of each of those charts. Chart 5US Treasury Market Oversold Episodes: 2008-2012 US Treasury Market Oversold Episodes: 2008-2012 US Treasury Market Oversold Episodes: 2008-2012 Chart 6US Treasury Market Oversold Episodes: 2013-2017 US Treasury Market Oversold Episodes: 2013-2017 US Treasury Market Oversold Episodes: 2013-2017 Chart 7US Treasury Market Oversold Episodes: 2018 To Today US Treasury Market Oversold Episodes: 2018 To Today US Treasury Market Oversold Episodes: 2018 To Today What does this look back tell us about looking ahead? The current episode, at only 105 days old, is still 62 days “younger” than the average oversold period, and 76 days “younger” than the average period where core inflation was rising. This would put the end of the current episode sometime in August. The ISM is essentially unchanged over the current episode so far, making it difficult to draw conclusions based on growth momentum – although the longest episode in 2018 shows that yields can trade sideways for a long time, even in the absence of a big slowing of growth, if the Fed is in a rate hiking cycle. However, the current episode differs dramatically from others in this analysis on two critical fronts. Core inflation has surged 1.6 percentage points since the oversold period began in February, far more than any other episode, while the gap between a rapidly increasing Fed Monitor and a flat 12-month Fed Discounter is also unique among post-2000 oversold periods. In other words, the Treasury market is still vulnerable to a repricing of Fed tightening expectations, especially with positioning and sentiment measures like the Market Vane survey and net futures positioning not yet at fully bearish extremes. Bottom Line: The current oversold condition in the US Treasury market can take another 2-3 months to unwind, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist Update: No Case For A Hawkish Turn Yet Australia has been one of the top performing government bond markets within the developed economies, as discussed earlier. This performance has occurred even with strong acceleration of both Australian economic momentum and market-based inflation expectations (Chart 8). Despite our RBA Monitor flashing pressure on the RBA to tighten, and the Australian OIS curve already discounting 48bps of rate hikes over the next two years, Australian bond yields have remained very well behaved during the “calm” second quarter for global fixed income. Chart 8RBA Policies Limiting Rise In Bond Yields RBA Policies Limiting Rise In Bond Yields RBA Policies Limiting Rise In Bond Yields Chart 9RBA Stimulus Takes Many Forms RBA Stimulus Takes Many Forms RBA Stimulus Takes Many Forms The continued dovish messaging from the Reserve Bank of Australia (RBA) is the main reason for the solid Australia bond performance. The central bank is signaling no imminent shift in its combination of 0.1% nominal policy rates, deeply negative real rates, yield curve control on 3-year bonds and quantitative easing on longer-maturity bonds (Chart 9). Other central banks are starting to inch towards reining in the massive monetary accommodation of the past year. Could the RBA be next? In a Special Report published back in January of this year, we outlined a list of variables to watch to determine when the Reserve Bank of Australia (RBA) could be expected to turn less dovish.2 This checklist would also inform our country allocation view on Australian government bonds, which has remained neutral. A quick update on the latest readings from the RBA Checklist shows little pressure on the RBA to begin preparing markets for tighter monetary policy. 1. The vaccination process goes quickly and smoothly We are NOT placing a checkmark next to this part of our RBA Checklist. Australia has weathered COVID-19 far better than most other Western countries in terms of actual cases and deaths, but the vaccine rollout Down Under has been underwhelming. Only 16% of the population has received at least one vaccine jab, while a mere 2% is fully vaccinated. These are numbers that are more comparable to pandemic-ravaged emerging market countries like India and Brazil where access to vaccines is an issue (Chart 10). Chart 10A Slow Vaccine Rollout Down Under A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields The slow vaccine rollout is less worrisome in light of the Australian government having secured enough vaccine doses to inoculate the entire population, and with the domestic economy facing limited remaining COVID-19 restrictions. The issue has been distribution and that is now occurring at a quickening pace. Until a much greater share of the population is vaccinated, however, Australia will continue to maintain aggressive COVID-related international travel restrictions – the government just announced that borders will remain shut until mid-2022 - that will be a major drag on the economically-important tourism sector. 2. Private sector demand accelerates alongside fiscal stimulus (✔) We ARE placing a checkmark next to this part of our RBA Checklist. Australia’s fiscal stimulus in response to the pandemic was one of the largest in the developed world. The stimulus was heavily focused on wage subsidies and income support measures like the JobSeeker program, which expired back in March. As the expensive stimulus programs are unwound, it is critical that the domestic economy can stand on its own without support. On that front, the news is good. Australia’s economy grew by 1.8% during Q1/2021, lifting the level of real GDP above the pre-pandemic peak (Chart 11). Both consumer spending and business investment posted solid growth during the quarter, fueled by surging confidence with the NAB business outlook measure hitting a record high in May (bottom panel). As a sign that the domestic economy is benefitting from a return to pre-pandemic habits, Q1 saw a 15% increase in spending in hotels, cafes and restaurants. That strength looked to extend into the Q2, with retail sales rising 1.1% in April, suggesting that Australian domestic demand is enjoying strong upward momentum. Chart 11A Confidence-Led Recovery In Domestic Demand A Confidence-Led Recovery In Domestic Demand A Confidence-Led Recovery In Domestic Demand Chart 12China Is A Drag On Australian Exports China Is A Drag On Australian Exports China Is A Drag On Australian Exports 3. China reins in policy stimulus by less than expected We are NOT placing a checkmark next to this part of our RBA Checklist. China is by far Australia’s largest trading partner, so Chinese demand is always an important contributor to Australian economic growth. This is why we included a China element in our RBA Checklist. Specifically, we deemed the outcome that would potentially turn the RBA more hawkish would be Chinese policymakers pulling back monetary and fiscal stimulus by less than expected in 2021 after the big policy support in 2020. The combined fiscal and credit impulse for China has already slowed by 9% of GDP since December 2020, signaling a meaningful cooling of Chinese growth in the latter half of 2021 that should weigh on demand for imports from Australia (Chart 12). However, Chinese import demand has already been severely impacted because of worsening China-Australia political tensions, which has led Beijing to impose restrictions on Australian imports for a variety of products, include coal, wine, beef, barley and cotton. The result is that there has been no growth in Australian total exports to China over the past year – an outcome that was flattered by the surge in iron ore prices - which has weighed on overall Australian export growth. Given this weak starting point for Chinese demand for Australian goods, the sharp reduction in the China stimulus is, on the margin, a factor that will not force the RBA to turn less dovish sooner than expected. 4. Inflation, both realized and expected, returns to the RBA’s 2-3% target We are NOT placing a checkmark next to this part of our RBA Checklist. Australian inflation remains well below the RBA’s 2-3% target range, with the headline CPI and the less volatile trimmed mean CPI both expanding at only a 1.1% annual rate in Q1/2021 (Chart 13). The RBA is forecasting a brief boost to both measures in Q2, before settling back below 2% to the end of 2022. Chart 13No Bond-Bearish RBA Policy Shift Without More Inflation No Bond-Bearish RBA Policy Shift Without More Inflation No Bond-Bearish RBA Policy Shift Without More Inflation Chart 14Diminishing Financial Stability Risks From Housing Diminishing Financial Stability Risks From Housing Diminishing Financial Stability Risks From Housing The RBA’s message on the inflation outlook has been very consistent. A sustainable move of realized inflation back to the 2-3% target range – that would prompt a normalization of monetary policy – cannot occur without a significant tightening of labor markets that drives wage growth back to 3% from the Q1/2021 reading of 1.5%. The RBA currently does not expect that outcome to occur before 2024. The RBA believes that the full employment NAIRU is between 4-4.5%, well below the OECD’s latest estimate of 5.4%. Given the sharp drop in Australian unemployment already seen over the past few quarters, there is the potential for an upside surprise in the wage data that could lead the RBA to change its policy bias. The central bank would need to see a few quarters of such wage surprises, however, before altering its forward guidance on the timing of future rate hikes. 5. House price inflation begins to accelerate We are NOT placing a checkmark next to this part of our RBA Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets were overheating could prompt the RBA to consider tighten monetary policy. The annual growth of median house prices has dipped from +8% in Q1 2020 to +4% in Q4 2020, despite robust housing demand as evidenced by the 40% growth in building approvals. At the same time, housing valuations have become less stretched with the ratio of median home prices to median household incomes falling -9% from the 2017 peak according to data from the OECD (Chart 14). The RBA remains sensitive to the potential financial stability risks from overvalued housing. The latest trends in the house price data, however, suggest that the central bank does not yet to have the use the blunt tool of tighter monetary policy to cool off an overheated housing market. Chart 15Upgrade Australia To Overweight (Vs. USTs) Upgrade Australia To Overweight (Vs. USTs) Upgrade Australia To Overweight (Vs. USTs) In sum, the majority of items in our RBA Checklist are signaling no immediate pressure on the central bank to tighten policy. The first 25bp rate hike is not discounted in the Australian OIS curve until April 2023, a little ahead of RBA guidance but still consistent with a very dovish policy bias. The inflation data, in our view, will be the critical factor that could prompt the markets to pull forward expected monetary tightening, leading to a surge in Australian bond yields. With the RBA already expecting a surge in inflation in the Q2/2020 data, the central bank would likely want to see at least a couple of more quarterly inflation prints – both for the CPI and wage price index - before signaling a more hawkish policy shift. Thus, the RBA will likely stay dovish over the latter half of 2021 Therefore, we are moving to an overweight recommended stance on Australian government bonds on a tactical (0-6 months) basis. In our model bond portfolio on pages 16-17, we are “funding” that shift to an above-benchmark weighting in Australia out of US Treasury exposure. Given our view that the Fed will soon begin to signal a 2022 taper of its asset purchases, relative policy dovishness should lead Australian government bonds to outperform US Treasuries in the latter half of this year. In addition, Australian bonds have a lower yield beta to changes in US Treasury yields, relative to the high beta to changes in non-US developed market yields (Chart 15), making allocations out of the US into Australia attractive from a risk management perspective in a global bond portfolio. Bottom Line: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation to Australian government bonds to overweight on a tactical investment horizon.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 See BCA Research Global Fixed Income Strategy Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20, 2018. 2 See BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Summer Nap For Global Bond Yields A Summer Nap For Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns