Financials

Neutral Time For A 20% Cash-in Time For A 20% Cash-in In this Tuesday’s Strategy Report we closed our overweight financials call and moved this GICS1 sector to neutral from previously overweight capitalizing 20% in relative gains, since last November’s inception. This move is a hedge to our rising inflation view, and we would rather stick to overweighting energy and industrials as ways to express our inflation protection theme as opposed to maintaining an above benchmark allocation in financials. There are some warning signs for the sector as well. The Fed’s easing cycle has reached a zenith and, at the margin, this will weigh on relative financials profitability (bottom panel). The shadow fed funds rate (courtesy of Leo Krippner1) has also troughed and is closing in on the zero line (middle panel). Finally, using the 10-year/shadow fed funds rate yield curve also signals that the yield curve may have peaked already, at least for this early part of the business cycle (top panel). Bottom Line: We downgraded the S&P financials sector to neutral in yesterday’s Strategy Report and pocketed gains to the tune of 20%, since inception.   Footnotes 1https://www.ljkmfa.com/test-test/international-ssrs/

Highlights Portfolio Strategy The rising shadow fed funds rate and related flattening of the yield curve, eerie similarities with the 2009/10 episode, overbought technicals, and extended sector breadth, all signal that financials are due for a breather. Downgrade to neutral and lock in relative gains of 20% since inception. Early signs of housing related euphoria turning into consternation, lack of an overall bank credit impulse, relative share price overbought conditions, a looming increase in bank non-performing loans as government spending programs are set to expire in the autumn, will more than offset compelling bank valuations and rising interest rates. Trim the S&P banks index to underweight.   Recent Changes We trigger our downgrade alert and trim the S&P financials sector to neutral today cementing gains of 20% since inception. Downgrade the S&P banks index to underweight today. Table 1 Litmus Test Litmus Test Feature Following the 9/11 attacks, the great Alan Abelson of Barron’s “Up And Down Wall Street” column, eloquently wrote: “The market is a mechanism for allocating capital and, of course, making us all rich. What it most decidedly isn't is a forum for venting civic sentiment. To equate buying stock with patriotism or selling stock with a lack of patriotism is balderdash, the equivalent of praising or damning a thermometer for the temperature it records (emphasis ours).” This last part of the quote has been with me ever since, and is relevant today in the context of rising inflation, the related further bond market selloff and the equity market’s looming reaction to it. Currently, one cannot blame the stock market for not really caring about inflation as it is the equivalent of blaming mercury-in-glass for taking the temperature. However, the Fed’s tapering of asset purchases is coming later this fall and there will be a market shakeout before the SPX reaches a new equilibrium, likely 10% lower than current levels. Over the past few weeks we highlighted ten reasons to lighten up on equities and five technical reasons not to chase equities higher in the near-term. Today we reiterate our short-term cautiousness on the prospects of the stock market and below is a detailed reminder of our thesis. Fourteen months ago we penned a report titled “20 Reasons To Buy Equities” and now that the SPX is up 2,000 points since that trough, the risk/reward tradeoff is to the downside and we are compelled to book gains and raise some cash. On May 3 we upgraded health care to overweight and added some defensive exposure to our portfolio and last week we highlighted five technical reasons not to chase equities higher in the near term. What follows are 10 reasons to lighten up on stocks and therefore await a better entry point to deploy fresh capital later this summer: 1. The Fed and other developed global central banks’ easing has reached a peak. In fact, taper has started at the BoC and the BoE announced a quasi-taper, the ECB is rumored to commence decreasing asset purchases this summer and the Fed will likely taper by yearend (Chart 1). 2. US fiscal easing has also hit an apex and a large fiscal cliff looms in 2022 a mid-term election year (Chart 2). Chart 1Yellow… Yellow… Yellow… 3. The bulls have taken full control of the equity market and our Risk Appetite Indicator recently touched the four standard deviations line (Chart 2). 4. The ISM manufacturing survey peaked near 65 and the non-manufacturing hit an all-time high (Chart 2). Chart 2…Flags… …Flags… …Flags… 5. China’s is in a slowdown mode and BCA’s total social financing projections indicate a further deceleration in the back half of the year (Chart 1).  6. Equity market internals have been signaling trouble since February, warning that this bifurcated market is in desperate need of a breather (Chart 3). 7. The VIX in mid-April had a 15 handle for the first time since early last year, warning that investors are complacent (Chart 3). 8. Similarly, the junk bond option adjusted spread is at cyclical lows, and financial conditions are as good as they get probing all-time lows (Chart 2). 9. SPX profit growth is slated to jump 34% in calendar 2021, according to the latest I/B/E/S estimates with EPS on track to hit an all-time high level of $188 (Chart 3). 10. Finally, valuations remain lofty with the forward P/E ratio hovering near 21 an historically high level (Chart 3). Bottom Line: The easy money has been made since the March 23, 2020 trough when the SPX was 2,000 points lower. Our sense is that the next 10% move in the SPX is lower (close to 3,800) rather than higher and a healthy and much needed reset looms. Thus, we recommend investors book some gains, raise some dry powder and be prepared to deploy fresh capital later this summer. This week we take profits on an early cyclical sector and trim to neutral, and downgrade one of its key industry groups to underweight. Chart 3…Waving …Waving …Waving Don’t Overstate Your Welcome In Financials Last November, we boosted the S&P financials sector to overweight as soon as we could following the Pfizer/BioNTech COVID-19 vaccine efficacy news, and since then this interest rate-sensitive sector has bested the SPX by 20%. Our sense is that the easy money has been made on this position and today we recommend investors lock in profits and downgrade exposure to neutral. There are a few reasons why we are compelled to monetize our handsome gains accrued over the past six months. First, this is a hedge to our rising inflation view, and we would rather stick to overweighting energy and industrials as ways to express our inflation protection theme as opposed to maintaining an above benchmark allocation in financials. The second part of our inflation Special Report on May 10 also warns against hiding in financials during bouts of inflation, further cementing our view of booking these significant relative gains for our portfolio. Second, the Fed’s easing cycle has reached a zenith and at the margin this will weigh on relative financials profits (fed funds rate shown as a year-over-year change and on an inverted scale, bottom panel, Chart 4). The shadow fed funds rate (courtesy of Leo Krippner)1 has troughed and is closing in on the zero line (shadow fed funds rate shown inverted, middle panel, Chart 4). Using the 10-year/shadow fed funds rate yield curve also signals that the yield curve may have peaked already, at least for this early part of the business cycle (top panel, Chart 4). Chart 4Don’t Overstay Your Welcome Don’t Overstay Your Welcome Don’t Overstay Your Welcome Chart 5Gruesome Parallel Gruesome Parallel Gruesome Parallel Third, typically, financials explode right out of the gate following a recession and if we use 2009/10 as a close parallel then there are high odds that financials stocks are entering a rather gruesome period as far as relative returns are concerned. Chart 5 plots relative share prices and has aligned the November 2020 bottom with the March 2009 trough. Early in the year, we posited that the SPX was following the 2009/10 episode to the tee and if history at least rhymes, financials are also in for a rude awakening. Fourth, technicals are overbought and near a level that has marked previous easing off phases in relative share prices (second panel, Chart 6). Moreover, breadth is as good as it gets: not only are the number of financials subgroups trading higher than their 40-week moving average glued to the 100% ceiling, but also earnings breadth has nowhere to go but down (third & bottom panels, Chart 6). However, we refrain from turning outright bearish on this early-cyclical sector as valuations remain bombed out and provide a large enough cushion to absorb any shocks (Chart 7). Chart 6Overstretched… Overstretched… Overstretched… Chart 7…But Undervalued …But Undervalued …But Undervalued In sum, the rising shadow fed funds rate and related flattening of the yield curve, eerie similarities with the 2009/10 episode, overbought technicals, and extended sector breadth, all signal that financials are due for a breather. Bottom Line: We trigger our downgrade alert and crystalize gains in the S&P financials sector of 20% since inception and downgrade exposure to neutral, today. Shy Away From Banks We execute our downgrade in the S&P financials sector to neutral by trimming the S&P banks index to a below benchmark allocation. Investors can treat this downgrade as a hedge to our oil & gas exploration & production and rails overweights, as well as a hedge against a failure of inflation rising further in the coming months. Importantly, there are clear elements of cooling in the red-hot housing market. Housing starts and permits came off the boil last week and failed to live up to economists’ upbeat expectations. Lumber is getting clobbered and entered a bear market having first surged to five standard deviations above its five decade mean. Moreover, the latest news from the University of Michigan survey of consumers’ sentiment on buying conditions for houses (top panel, Chart 8) made for grim reading, signaling that a key bank loan category, mortgage credit, is in for a rough summer/fall season. Chart 8Is Housing Cresting? Is Housing Cresting? Is Housing Cresting? Tack on the nosedive in mortgage applications for purchasing a new home courtesy of rising mortgage rates, albeit from a low base, and factors are falling into place for an underperformance phase in banks (bottom panel, Chart 8). Were it only for housing related credit, we would overlook it as a single yellow flag. However, our credit impulse diffusion indicator – gauging the eight credit categories that the Fed tracks – is sinking like a stone, especially on a 13- and 52-week basis (Chart 9). Such broad based weakness warns that organic growth in bank profits (as opposed to buybacks) will be hard to come by in the coming quarters. Stimulus checks and a sharply rising fiscal deficit have served as a shot in the arm for consumers, businesses, landlords and banks, and have kept the economy going. However, as these liquidity taps dry out come autumn, it will be more difficult to continue to kick the proverbial can down the road. In other words, delinquency rates should tick higher and further infect non-performing loans (Chart 10). Granted, banks had provisioned aggressively last year and have been releasing reserves of late, but at the margin this will likely prove a net negative for their earnings.   Chart 9No Credit Pulse No Credit Pulse No Credit Pulse Chart 10NPLs On The Rise NPLs On The Rise NPLs On The Rise Two additional words of caution. First, cyclical momentum is as good as it gets for relative share prices. Banks have run too far too fast and a lot of the good news is already baked in as the middle panel of Chart 11 highlights. Second, while valuations remain bombed out, it is worrisome that banks have failed to make any real progress on narrowing the gap between ROE and P/B metrics since the GFC, unlike following the Savings & Loans and 9/11 catalyzed recessions (bottom panel, Chart 11). The implication is that banks are a value trap rather than a value opportunity. Finally, one key risk to our modestly bearish bank undertone, is the US 10-year Treasury yield. Relative bank performance and interest rates have been joined at the hip since the GFC aftermath as the Fed anchored short rates on the zero lower bound, thus shifting the sensitivity of bank profits to the long end of the curve versus the shape of the curve. If interest rates started galloping higher investors would initially seek the “safety” of bank earnings that would get a fillip from rising net interest margins and put our negative bank view offside (Chart 12). Chart 11Highest Momentum Since the GFC, But Valuations Are Nonresponsive Highest Momentum Since the GFC, But Valuations Are Nonresponsive Highest Momentum Since the GFC, But Valuations Are Nonresponsive Chart 12Risks To Monitor Risks To Monitor Risks To Monitor Netting it all out, early signs of housing related euphoria turning into consternation, lack of an overall bank credit impulse, relative share price overbought conditions, a looming increase in bank non-performing loans as government spending programs are set to expire in the autumn, will more than offset compelling bank valuations and rising interest rates. Bottom Line: Trim the S&P banks index to underweight, today.  The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, PNC, TFC, FRC, FITB, SIVB, KEY, MTB, RF, CFG, HBAN, CMA, ZION, PBCT.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.ljkmfa.com/test-test/international-ssrs/ Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? ​​​​​​​ Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 ​​​​​​​Favor value over growth

Highlights The selloff in crypto-currencies on May 19 may be overblown but the risk of government intervention is a rising headwind for this asset class. While environmental concerns are a threat to Bitcoin, the entire crypto-currency complex faces a looming confrontation over governance. Digital currencies are a natural evolution of money following coinage and paper. Moreover a sizable body of consumers is skeptical of governments and traditional banking. Loose monetary conditions are fueling a speculative mania. However, governments fought for centuries to gain a monopoly over money. As crypto-currencies become more popular, governments will step in to regulate and restrict them. Central bank digital currencies (CBDCs) threaten to remove the speed and transactional advantage of crypto-currencies, leaving privacy/anonymity as their main use-case. Feature The prefix “crypto” derives from the Greek kruptos or “hidden.” This etymology highlights one of the biggest problems confronting the crypto-currency craze in financial markets today. Speed and anonymity are the greatest assets of the digital tokens. But the former advantage is being eroded by competitors while the latter is becoming a political liability. In the 2020s, governments are growing stronger and more interventionist, not weaker and more laissez faire. Chart 1Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Bitcoin and rival crypto-currency Ethereum fell by 29.5% and 43.2% in intra-day trading on May 19, only to finish the day down by 13.8% and 27.2%, respectively. The market panicked on news that China’s central bank had banned firms from handling transactions in crypto-currencies. What really happened was that China’s National Internet Finance Association, China Banking Association, and Payment and Clearing Association issued a statement merely reiterating a 2013 and 2017 policy that already banned firms from handling transactions in crypto-currencies. These three institutions also warned about financial speculation regarding crypto-currencies.1 The crypto market suffered a spike in volatility because it is in the midst of a speculative mania. In the last five years, total market capitalization of crypto-currencies has risen from around $7 billion to $2.3 trillion,2 recording a 34,000% gain. Some crypto-currencies have even recorded returns in excess of that number over a shorter horizon. Price gains have been driven by retail buyers who may or may not know much about this new asset class (Chart 1). Prior to the May 19 selloff, prices had grown overextended and recent concerns over the environment, sustainability, and governance (ESG) had shaken confidence in Bitcoin and its peers. Chinese authorities have already banned financial firms from providing crypto services in a bid to deter ownership of crypto-currencies. And China is not alone. The latest market jitters are a warning sign that government interference in the crypto-currency market is a real threat. Regulation and sovereign-issued digital currencies are starting to enter the fray. While ultra-dovish central bank policies are not changing soon, and therefore crypto-currency price bubbles can continue to grow, crypto-currencies will remain subject to extreme volatility and precipitous crashes. In this report we argue that the fundamental problem with crypto-currencies is that they threaten the economic sovereignty of nation-states. Environmental degradation, financial instability, and black market crime, and other concerns about cryptos have varying degrees of merit. But they provide governments with ample motivation to pursue a much deeper interest in regulating a technological innovation that has the power to undermine state influence over the economy and society. Government scrutiny is a legitimate reason for crypto buyers to turn sellers. Does The World Need Crypto-Currencies? Broadly speaking, there are two primary justifications for crypto-currencies, centered on a transactional basis: speed and privacy/anonymity. The crux of crypto-currency creation rests on these two use cases.3 The speed of crypto-currencies comes from their ability to increase efficiency in local and global payment systems by facilitating financial transactions without the need of a third party (e.g. a financial institution). Cross-border settlement of traditional (fiat) currency transactions processed through the standard SWIFT communications system takes up to two business days. Most transactions involving crypto-currencies over a blockchain network are realized in less than an hour, cross-border or not.4 The fees involved with third-party payments are often more expensive than transacting with crypto-currencies. Simply put, excluding the “middleman” can save money. This is a selling point in a global market that expects to see retail cross-border transactions reach $3.5 trillion by the end of 2021, of which up to 5% are associated with transaction-based fees.5 But this breakthrough in payment system technology can be overstated and is not the main reason for using crypto-currency. Speculation drives current use, especially given that there is speculative behavior even among those who believe that cryptos are safe-haven assets or promising long-term investments (Chart 2). Chart 2Crypto-Currency Use Driven By Speculation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 3Consumers Growing Skeptical Of Banking Regulation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide If a person wants to buy an item from a company in a distant country, that person could use a crypto-currency just as he or she could use a credit card. Both parties would have a secure medium of exchange but, unlike with a credit card, both would avoid using fiat currencies. Neither party could conduct the same transaction using gold or silver. The crucial premise is the existence of an online community of individuals and firms who for one reason or another want to avoid fiat currencies. From a descriptive point of view, the crypto-currency phenomenon implies a lack of trust in modern governments, or at least their monetary systems, and an assertion of individual property rights. The list of crypto-currencies continues to grow. To date, there are approximately 9,800 of them. Some are trying to prove their economic value or use, while others have been created with no intended purpose or problem to solve. Even so, there has yet to be a crypto-currency that overwhelms the use of slower fiat money. In a recent Special Report, BCA Research’s Foreign Exchange Strategist Chester Ntonifor showed that crypto-currencies still have a long way to go to have a chance at replacing fiat monies. While crypto-currencies are showing signs of significant improvement as mediums of exchange, they still fall short as stores of value and units of account. The other primary case for crypto-currencies is privacy or anonymity. The bypassing of intermediaries implies a greater control of funds by the two parties of a transaction. Crypto-currencies are said to be more “private” compared to fiat money. Fiat money is controlled by governments and banks while crypto-currencies have only “owners.” Crypto-currencies are anonymous because they are stored in digital wallets with alphanumeric sequences – there is a limited personal data trail that follows crypto-currency compared to those of electronic fiat currency transactions. In a post-9/11, post-GFC, post-COVID world where a sizable body of consumers is growing more skeptical of government surveillance and regulation and banking industry practices (Chart 3), crypto-currencies give users more than just a means to transact with. However, privacy is not the same as security. Hacking and fraud can affect cryptos as well as other forms of money and attacks will increase with the value of the currencies. Bitcoin At The Helm Of Crypto-Currency Market Chart 4Bitcoin Slows Bitcoin Slows Bitcoin Slows Bitcoin has cemented its status as the number one currency in the crypto-verse.6 It is considered to be the first crypto-currency created, it is the most widely accepted, it is touted as a store of value or “digital gold,” and it is the most featured in quoting alternative crypto-currency pairs across crypto exchanges. As it stands, Bitcoin accounts for around 42% of total crypto-currency market capitalization.7 This share has declined from around 65% at the start of 2021 on the back of the frenzied rise of several alternative coins.8 But rising risks to Bitcoin’s standing will cause the entire crypto-market to retreat. In a Special Report penned in February, BCA Research’s Chief Global Strategist Peter Berezin argued that Bitcoin is more of a trend than a solution and that its usefulness is diminishing. Bitcoin’s transaction speed is slowing and its transaction cost is rising (Chart 4). Slowing speed and rising cost on the Bitcoin network are linked to a scalability problem. The crypto-currency’s network has a limited rate at which it can process transactions related to the fact that records (or “blocks”) in the Bitcoin blockchain are limited in size and frequency. This means that one of its fundamental justifications, transactional speed, will become less attractive over time, should the network not address these issues. Bitcoin also consumes a significant amount of energy, a controversy that is gaining traction in the crypto-currency market after Elon Musk, the “techno-king” of Tesla, cited environmental concerns in reversing his decision to accept Bitcoin payment for his company’s electric vehicles. Energy consumption rises as more coins are mined, since mining each new Bitcoin becomes more computer-power intensive. The need for computing power and energy will continue to increase until all 21 million Bitcoins (total supply) are mined, which is currently estimated to occur by the year 2140. Strikingly, the energy needed to mine Bitcoin over a year are comparable to a small country’s annual power consumption, such as Sweden or Argentina (Chart 5). Chart 5Bitcoin Consumes More Energy Than A Small Country … Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin also generates significant quantities of electronic waste (Chart 6). Chart 6… And Generates A Lot Of Electronic Waste Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin mining is heavily domiciled in China, which accounts for 65% of global mining activity (Figure 1). China’s energy mix is dominated by coal power, which makes up approximately 65% of the country’s total energy mix even after a decade of aggressive state-led efforts to reduce coal reliance. Of this, coal powered energy makes up approximately 60% of Bitcoin’s energy mix in China.9 With several countries aiming to minimize carbon emissions, and with approximately 60% of Bitcoin mining powered by coal-fired energy globally,10 Bitcoin imposes a major negative environmental impact. Figure 1Bitcoin Mining Well Anchored In Asia Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin does not shape up well when compared to gold’s energy intensity either. Bitcoin mining now consumes more energy than gold mining over a single year. While the energy difference is not large, the economic value is. Gold’s energy consumption to economic value trade-off is lower than that of Bitcoin. The production value of gold in 2020 was close to $200 billion, while Bitcoin was measured at less than $25 billion (Chart 7A). On a one-to-one basis, gold even has a lower carbon footprint than Bitcoin (Chart 7B). Chart 7AGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 7BGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Crypto-currency energy consumption and carbon footprint will attract the attention of government regulators. Of course, not all crypto-currencies are heavy polluters. But if the supply of cryptos is constrained by mining difficulties then they will require a lot of energy. If the supply is not constrained then the price will be low. Government Regulation Is Coming Environmental concerns point to the single greatest threat to crypto-currencies – the Leviathan, i.e. the state. In this sense the crypto market’s wild fluctuations on May 19, at the mere whiff of tougher Chinese regulation, are a sign of what is to come. Governments around the world have so far left crypto-currencies largely unregulated but this laissez-faire attitude is already changing. Environmental regulation has already been mentioned. Governments will also be eager to expand their regulatory powers to “protect” consumers, businesses, and banks from extreme volatility in crypto markets. But investors will underrate the regulatory threat if they focus on these issues. At the most basic level, governments around the world will not sit idly by and lose what could become significant control of their monetary systems. The ability to establish and control legal tender is a critical part of economic sovereignty. Governments won control of the printing press over centuries and will not cede that control lightly. If crypto-currencies are adopted widely, then finance ministries and central banks will lose their ability to manipulate the money supply and the general level of prices effectively. Politicians will lose the ability to stimulate the economy or keep inflation in check. Most importantly, while one may view such threats as overblown, it is governments, not other organizations, that will make the critical judgment on whether crypto-currencies threaten their sovereignty. Throughout the world, most crypto-currency exchanges are regulated to prevent money laundering. Crypto-currencies are not legal tender and, aside from Bitcoin, their use is mostly banned in China (Table 1). However, more specialized regulation that targets energy and economic use has yet to be brought into law across the world. Table 1World Governments Will Not Relinquish Hard-Fought Monopolies Over Money Supply Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In China, initial coin offerings (ICOs – the equivalent of an initial public offering on the stock market) and trading platforms are banned from engaging in exchanges between the yuan and crypto-currencies or tokens. In fact, China recognizes crypto-currencies only as virtual commodities or virtual property. India is another country where exchanges and ICOs are banned. While crypto-currencies are not banned, they are not legal tender. Indian policymakers have recently proposed banning crypto-currencies, however. The proposed legislation is one of the world’s strictest policies against crypto-currencies. It would criminalize possession, issuance, mining, trading, and transferring crypto-assets. If the ban becomes law, India would be the first major economy to make holding crypto-currency illegal. Even China, which has banned mining and trading, does not penalize possession. In the US, Secretary of the Treasury Janet Yellen has already expressed concerns regarding the illicit use of cryptos for supposed criminal gain.11 She is in alignment with European Central Bank President Christine Lagarde. Because of the anonymity of crypto-currencies, identifying users behind illicit transactions is difficult. This means regulators face headwinds in identifying transactions that are made for criminal gain, as compared to fiat transactions. Governments have long dealt with the anonymity of cash but they have ways of monitoring bank accounts and paper bills. Crypto-currencies are beyond their immediate sight of control and therefore will attract growing scrutiny and legislative action in this regard. The Colonial Pipeline ransomware attack on May 7, which temporarily shuttered about 45% of the fuel supply line for the eastern United States, illustrates the point. The DarkSide group of hackers who orchestrated the attack demanded a ransom payment of $4.4 million worth of Bitcoin, which Colonial Pipeline paid them on May 7. Shortly thereafter, unspecified “law enforcement agencies” clawed back the $4.4 million from the hackers’ account (transferring it to an unknown address) and DarkSide lost access to its payment server, DOS servers, and blog. This episode should not be underrated. It was a successful, large-scale cyber-attack on critical infrastructure in the world’s most powerful country. It highlighted the illicit uses to which crypto-currencies can be put. True, criminals demand ransoms in fiat money as well – and many crypto-currency operators will distance themselves from the criminal underworld. Nevertheless governments will give little slack to an emerging technology that presents big new law enforcement challenges and is not widely used by the general public. Ultimately governments will pursue their sovereign interests in controlling money, the economy, and trade, listening to their banking lobby, expanding their remit to “protect” consumers, and cracking down on illicit activity. Governments are not capable of abolishing crypto-currencies altogether, or the underlying technology of blockchain. But they will play a large and growing role in regulating them. Central Banks Advancing On Digital Currencies Central bank digital currencies (CBDCs) will leave crypto-currencies in the realm of speculative assets. CBDCs are a form of digital money denominated in a country’s national unit of account and represent a liability on a central bank’s balance sheet. This is different from current e-money that represents a claim on a private financial institution’s balance sheet. It is also different from crypto-currencies, because there is a central authority behind a CBDC, unlike with crypto-currencies due to their decentralized nature. In China, the People’s Bank of China (PBoC) has suggested its rollout of a digital yuan is “ready” despite no release to date. Beta testing is ongoing in several provinces. The PBoC’s justification for a digital yuan comes from China’s growing cashless economy. The transition away from cash is largely thanks to mobile payment platforms like Alibaba’s Alipay and Tencent’s WeChat Pay, which, between the two of them, control almost the entire mobile payments market of some 850 million users. There is a significant amount of systemic risk in this system – one reason why Chinese authorities have recently subjected these companies to new scrutiny and regulation. Should Alibaba or Tencent go bankrupt, the local payment system will crash. The PBoC’s efforts will increase competition in the local payments space and reduce this systemic risk. Policymakers are also concerned that as Chinese citizens choose to hold their money in digital wallets provided by Alibaba and Tencent instead of bank accounts, liquidity is being drained from the traditional banking system, putting deposit levels at banks under strain, and posing risks to liability matching. The digital yuan will still involve a third party, unlike crypto-currencies which do not. Doing away with commercial banks is not a reality – indeed the Chinese Communist Party seeks to buttress the state-owned commercial banks in order to maintain control of the economy. What the digital yuan does, and other CBDCs will do too, is utilize blockchain technology, which is faster and more secure than traditional payment networks. In the US, the Fed has been studying the viability of a CBDC US dollar. The Fed has stated that it is carefully exploring whether a CBDC will lead to “safer, less expensive, faster, or otherwise more efficient payments.” While the Fed has yet to find a single standout case for a CBDC US Dollar, Fed Chair Jerome Powell said last year that the US has a “competitive payments market” with “fast and cheap services, particularly in comparison to other nations exploring a CBDC.” To date, the Fed’s observation is that many of the challenges that CBDCs hope to address do not apply to the US, including disuse of physical cash, narrow reach or high concentration of banking, and weak infrastructure for payment systems. Rather, the Fed is more focused on developing the FedNow real-time payment system for private banks. This is much the same as in Europe, where physical cash still plays a major role in day-to-day economic activity and where local payment systems are fast and secure. But central banks around the world continue to engage in work centered around CBDCs (Charts 8A and 8B) – and China’s progress will encourage others to move faster. Advanced economies are mostly interested in creating a safer and more efficient payment system, while emerging and developed economies have interest across several areas such as financial stability, monetary policy setting, and inclusiveness of banking, as well as efficiency and safety (Chart 9). CBDCs are especially attractive to emerging market policy makers at targeting those who lack access to traditional banking. Chart 8ACentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 8BCentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 9Central Banks CBDC Interest Areas Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In remote areas, access to banking is scarce and expensive. CBDCs can help solve this problem. Individuals would have CBDC accounts directly on a central bank ledger. They could then access their money and transact through a digital wallet application that is linked to the CBDC account. Giving people access to digital currency would allow them to transact quickly, in remote settings, without the need of hard currency. Monetary policy transmission is also better in advanced economies. In emerging markets, there are bottlenecks in local financial markets. Looser central monetary policy does not always translate into cheaper financing across the economy. In remote and poverty stricken areas, monetary policy transmission is sticky, meaning high costs of borrowing can persist even through accommodative policy cycles. This is a smaller issue in advanced economies. Payment systems in advanced economies are due an overhaul in security and efficiency, and CBDCs and blockchain technology will provide this. CBDCs will prove to be just as efficient to transact with as any crypto-currencies available today. CBDCs will also be legal tender and accepted by all vendors. The anonymity factor will be lost but this will not be a problem for most users (whereas legal issues will become a problem for crypto-currencies). The probability of central banks issuing CBDCs in both the short and medium term, both in the retail and wholesale space, is rising. If advanced economies like those of the G7 issue CBDCs soon, policy makers will undoubtedly ensure the use of it over the currently circulating and partially accepted crypto-currencies. The endgame will leave crypto-currencies in the highly speculative asset class, perhaps even in the black market where anonymity is valued for transactions that wish not to be tracked. Investment Takeaways Prices of crypto-currencies may continue to rise given sky-high fiat money creation amid the COVID pandemic and ultra-low interest rates. Digitalization is the natural next step in the evolution of money from precious metals to paper banknotes to electronic coin. But the market leader, Bitcoin, is encountering more headwinds. The primary case for the use of Bitcoin is challenged due to slowing transaction speeds and rising transaction costs. The virtual currency is primarily mined using coal-powered energy, resulting in growing scrutiny from governments and consumers. Government regulation is entering the ring and policymakers will take an increasingly heavy-handed role in trying to ensure that cryptos do not undermine economic sovereignty, financial stability, and law and order. When central banks begin to rollout digital currencies, especially those domiciled in advanced economies, crypto-currencies as medium of exchange will lose much of their allure. Crypto-currencies will remain as anti-fiat currencies and speculative assets. Risks To The View Given the controversy surrounding crypto-currencies, it is only fair to state outright the risks to our view. We would also recommend clients read our colleague Dhaval Joshi’s latest bullish take on Bitcoin. First, scaling up Bitcoin’s network and processing transactions in batches instead of single transactions will resolve transaction time and cost risks, restoring efficiency. This is a clear solution to efficiency concerns. However, scaling and batching transactions are not on the immediate horizon of Bitcoin developers. Bitcoin’s network will still need to undergo another “halving” in order for this risk to subside and for the network to scale. A halving of the network will only occur again in 2024.12 Second, on the environment: Bitcoin mining is not solely dependent on fossil fuel energy that gives it a “dirty” footprint. Renewables already make up some 25% of Bitcoin mining. Increasing the use of renewables in Bitcoin’s energy mix will help lower its environmental impact. However, this is easier said than done. Global renewable energy has yet to scale up to a point where it can consistently out-supply existing fossil-fuel energy. Mining hardware also has its associated carbon footprint that would need to be addressed. And location matters too. Crypto-currency mining farms are large-scale projects. Simply uprooting operations to a country that could lower the carbon footprint of a mining farm or two is not viable due to the costs involved. Hence crypto-currency mining will probably continue to be a “dirty” operation but a rapid shift to renewables would challenge our thesis. Bitcoin’s network is also based off a “proof of work” protocol. Miners must prove that a certain amount of computational effort has been expended for confirming blocks on the network, allowing transactions to be processed. Proof of work is energy intensive. Other crypto-currencies, like Ethereum, will adopt a “proof of stake” protocol. Simply put, transactions are confirmed by users and their stake in the associated crypto-currency. Proof of stake is less energy intensive compared to proof of work. Third, as to government regulation, the longer policymakers take to enact legislation targeting crypto-currencies, the larger their market will grow. Regulation in China and India may set a benchmark for major economies but not all will follow in the Asian giants’ footsteps. Some governments have been slow to study crypto-currencies, meaning legislation aimed at governing or regulating them may still be long in coming. Innovation is a good thing and free economies will not wish to restrain crypto-currencies or blockchain technology unduly, for fear of missing out. Fourth, on CBDCs, some central banks may only adopt them based on their respective economic needs. However, rising crypto-currency populism drives associated economic risks which can force the hands of central banks to adopt CBDCs in lieu of said needs. Each country faces unique challenges. Some central banks may not want to be left behind even if they believe their policy framework is facilitating economic activity efficiently. While the Fed has stated that it will not adopt a CBDC for the primary reason of ensuring payment security since it believes it already has a safe system in place, this view will change. The Fed could justify a move to a CBDC US dollar on the single basis of transitioning to a more sophisticated technology for the future. The Fed will not want to be caught behind the curve considering the PBoC is priming its digital yuan for release soon. Technological leadership is a strategic imperative of the United States and that imperative applies to financial technology as well as other areas.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Muyao Shen, “China Reiterates Crypto Bans From 2013 and 2017”, coindesk, May 18, 2021, coindesk.com. 2 As of May 11, 2021. 3 There are several other reasons or “problems” that crypto-currencies are created for or to solve, but speed and privacy form the basis of crypto-currencies first coming into existence. 4 Not all crypto-currencies transact in less than an hour. But there are many that transact in several minutes and in some cases, mere seconds. As the leading crypto-currency, Bitcoin takes approximately one hour for a transaction to be fully verified over its network. 5 “McKinsey’s Global Banking Annual Review”, McKinsey, Dec. 9, 2020, mckinsey.com. 6 We use Bitcoin as an example to understand the risk and impact of forthcoming government regulation and competition. Because of Bitcoin’s status, any significant risks that threaten the crypto-currency’s standing as the number one currency will threaten the entire market. 7 As of May 20, 2021. Figure varies daily. See www.coinmarketcap.com for more information. 8 Alternative currencies such as Ethereum, Ripple, Binance Coin, Dogecoin, and Cardano have chipped away at Bitcoin’s crypto-market dominance through 2021. 9 According to The Center For Alternative Finance, The University Of Cambridge. 10 According to The Center For Alternative Finance, The University Of Cambridge. 11 Data on the use of crypto-currencies for illicit activitiessays otherwise. Of all crypto-currency transactions, it is estimated that only 2.1% are used for illicit activities. See “2021 Crypto Crime Report”, Chainalysis, chainalysis.com. 12 A Bitcoin halving is when the reward for mining Bitcoin transactions is cut in half. This event also cuts Bitcoin's inflation rate and the rate at which new Bitcoins enter circulation, in half. Bitcoin last halved on May 11, 2020.

In the previous Tinkering With Inflation Special Report, we outlined our structural view for US inflation, namely that over the next 10 years inflation will surprise to the upside largely driven by politicians re-discovering the magic of fiscal spending. In today’s Special Report, we look at structural GICS1 sector-level implications for portfolio allocation courtesy of the looming inflationary flux, but with a major caveat. Over the years we have published numerous reports answering the question of “what to buy and what to sell” when inflation comes and goes. But, the key criticism is that our previous inflationary analysis included data from the current disinflationary era. In other words, the data was capturing the effects of reflation (i.e. inflationary spikes within the broader deflationary megatrend), rather than effects of the pure-play inflation (i.e. inflationary spikes within the broader inflationary trend). Up until recently, such analysis was well-fit for the macro environment investors were in, but given our structurally inflationary view, it pays to take a closer look at the relative GICS1 sector performance during “true” inflationary periods. The shaded areas in Chart 1 display five pure-play inflationary periods that we analyse in this Special Report. Importantly, we also treat the very first iteration with a big grain of salt as it was catalyzed by a one-off event: excessive Department of Defense (DoD) Vietnam War and Star War spending, which in turn skewed relative sector performance results (similarly to how relative sector performance during the recent pandemic-induced recession is not indicative of the typical recessionary sector performance). The Line In The Sand Before we proceed with our sectorial analysis, we must first distinguish between moves in core CPI that constitute deflation and inflation. We rely on empirical data and examine in detail the relationship between core CPI inflation, interest rates, and equites. Starting with equites, we find that the S&P 500 P/E multiple typically peaks when core CPI inflation reaches 2.3% and begins to decline once inflation climbs above 2.5% (Chart 2). At this level the market no longer finds the prospect of investing in long duration assets attractive. The investment horizon shortens as well as the multiple market participants are willing to pay for future earnings. The only adjustment we make to the 2.5% number is instead of looking at a specific inflection level, we turn it into a range of 2.3-2.7%. Chart 1True Inflationary Episodes True Inflationary Episodes True Inflationary Episodes Chart 2Inflation And The P/E Multiple Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Next, we bring fixed income into the picture and look at the correlation between SPX returns and changes in the 10-year US Treasury yield. The changes in this correlation help to distinguish between deflationary and inflationary environments due to different causality routes that exist from bonds to stocks, versus from stocks to bonds. A concrete example will help to clarify the point. When bond yields rise, they push stock prices down resulting into a negative causal correlation from yields to stocks. On the other hand, if stocks fall, then the central bank has to cut rates to protect the stock market, and in doing so it lowers yields. The end result is a positive causal correlation from stocks to yields. Negative correlation: yields rise ➜ DCF discount factor rises ➜ stocks fall Positive correlation: stocks fall ➜ central bank cuts rates ➜ yields fall Every central bank has to make the choice in which one of these two structural casual loops they operate as they can only protect one asset: either the bond market from inflation or the stock market from deflation. The choice of that key asset reveals the inflationary vs. deflationary regime. The bottom panel of Chart 3 illustrates this interplay. The top panel of Chart 3 also plots our 2.3%-2.7% inflation/deflation core CPI inflection range. Every time core CPI approached this critical range, the correlation between SPX returns and changes in the 10-year yield snapped to zero in preparation for a structural paradigm shift. This empirical exercise further illustrates that the 2.3-2.7% band in core CPI is the border between inflation and deflation. Chart 3The Border Line The Border Line The Border Line What follows is a select GICS1 sector return/positioning analysis during bouts of actual inflation. We also mainly focus on cyclical sectors since positioning within defensive GICS1 sectors is not driven by inflation, but instead it is dictated by global growth dynamics, which are beyond the scope of this Special Report.   Arseniy Urazov Senior Analyst ArseniyU@bcaresearch.com   Positioning For True Inflation: S&P Consumer Discretionary It is no secret that consumers don’t like CPI inflation as it erodes purchasing power via a multitude of channels. High interest rates that go toe to toe with inflation make big item purchases more challenging due to the higher cost of credit, hence weighing on end-demand for consumer discretionary stocks. Also, there is only so much cost pressures companies can pass onto the US consumer. The implication is that there comes a time when the entire S&P consumer discretionary sector is forced to sacrifice margins and profits. Chart 4 shows our consumer drag indicator that encapsulates both of these factors. Our thesis is that should true inflation return, the underperformance period is likely to be more severe compared with previous historical episodes (Chart 6). The reason for such a grim forecast has to do with the present-day sector composition. Following the inclusion of TSLA in this GICS1 sector, the combined exposure to AMZN and TSLA is 53% (Chart 5). Chart 4Inflationary Headwinds Inflationary Headwinds Inflationary Headwinds Chart 5Overconcentration Overconcentration Overconcentration Chart 6Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Both of these companies are effectively a long duration trade, which disproportionately benefited from low rates via the multiple expansion channel. Should inflation return to the system and end the era of low rates, both TSLA and AMZN will fall out of investor’s favor and heavily weigh on the overall S&P consumer discretionary sector. Finally, the bottom panel of Chart 6 shows the impressive run consumer discretionary stocks had since the beginning of the millennium rising by over 100% in relative terms. The rise is also in sharp contrast to the performance from 1975 to 2000 when the sector was range bound. The implication is that should an inflation-induced normalization period take root, the risk/reward in the S&P consumer discretionary sector will lie to the downside. Bottom Line: The S&P consumer discretionary sector will underperform in an inflationary world. Positioning For True Inflation: S&P Financials Similar to their early cycle brethren consumer discretionary stocks, investors should shy away from financials when the inflation genie is out of the bottle. Outside of the anomaly Vietnam War/Moon Landing period, Chart 7 reveals that inflation is a major headwind for financials. Chart 7Inflation & Financials Equities Inflation & Financials Equities Inflation & Financials Equities There are several avenues through which it hurts the sector. The first one is the yield curve. When the Fed raises short term rates to combat inflation, it flattens the curve. The end result is that the yield curve is flatter during an inflationary era, meaning that the spread between borrowing and lending narrows for the banking sector and results in a net interest margins squeeze. As a result, profitability drops, and stock prices fall (Chart 7, bottom panel). Inflation also hurts S&P financials due to the mismatch between banks' assets and liabilities. A typical bank has longer maturity for its receipts stream than for its liabilities. Consequently, as inflation rises, it reduces the future net inflow because creditors demand higher interest rates, while the returns earned by the bank on its current loan book is mostly fixed by existing contracts. The net result is lower bank equity and subsequently lower stock prices. The example below adds more color to the argument. Table 1 shows a stylized example of a balance sheet for a commercial bank over the course of three years with the following assumptions: Table 1The Effect Of Inflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Inflation from Year 1 to Year 2 is 5%, but it increases from Year 2 to Year 3 to 10% The bank's contracts with creditors mature in 1 year, while loans mature in 2 years Reserve requirements against all deposits are 10% Nominal interest rates on loans stand at 5% Interest rates on deposits stand at 4.5% Cash account is ignored as it doesn’t affect qualitative results The bank starts in Year 1 and extends $1,000 worth of loans maturing in two years with a 5% rate and receives $1,000 worth of deposits that grow at 4.5% per year and mature next year. The bank also has 10% ($100) of its liabilities in reserves. The difference between assets and liabilities is the bank’s equity or market value, which is also $100. Next year, the bank receives $50 (5% of $1000) in income from the loans it extended in Year 1, but a portion of this income has to be moved to reserves as the value of deposits increased by $45 (4.5% of $1000). Thus, the final value of loans is $1050 minus ($45 times the 10% reserve requirement), which equals $1045.5. The bank’s nominal equity value also increased to $105, but when adjusted for inflation it remains the same as in Year 1. Now, expected inflation for Year 3 changes from 5% to 10%, and since deposits have matured, creditors renegotiate them at a new rate of 10%, while the loans that were issued in Year 1 remain contractually bind to the original 5%. Crunching the numbers for Year 3 using new interest rates reveals that both the nominal and real value of a bank’s equity decreased due to the maturity mismatch between its assets and liabilities. Of course, the bank could have extended new loans in Year 2 at the higher 10% rate, but it would have only reduced the drop in equity value, but not eliminated it, so for the sake of simplicity we ignored that option. What this exercise showed is the second avenue through which inflation weighs on banks, and by extension, financials equities. Bottom Line: It pays to shy away from the S&P financials sector during bouts of inflation. Positioning For True Inflation: S&P Energy The S&P energy index is a classic inflation beneficiary as true inflationary impulses are synonymous with oil price surges. Chart 8 highlights how this commodity-driven sector was quick to react to all six inflationary spurts, besting the market during each of them. Chart 8Inflation & Energy Equities Inflation & Energy Equities Inflation & Energy Equities Moreover, deglobalization is likely to provide a boost to relative energy prices over a multi-year time horizon as the number of proxy wars in South America and the Middle East will likely increase, undercutting global oil supply. Hence, the geopolitical risk premia in crude oil will also rise boosting the allure of energy stocks. Finally, for investors who are choosing between energy and materials equites to express their near-term inflationary view, we would recommend sticking to the S&P Energy index in light of our unfolding China slowing down view. Chart 9 also depicts how China's dominance in the materials market is nearly absolute compared to the one in energy space. Hence, materials equities are more sensitive to the China weakness story, and investors should at the margin prefer energy equities over materials. Stay tuned for an upcoming report that will explore this idea in greater depth and recommend a new intra-commodity complex pair trade. Bottom Line: The S&P energy sector will outperform the market should deflation recede. Chart 9China And Commodities China And Commodities China And Commodities   Positioning For True Inflation: S&P Industrials The S&P industrials sector is located in the middle of the economic value chain and thus it has diminishing power to pass on inflationary cost increases especially energy related ones. At the same time, capital goods producers have other corporations as their end-demand user, which means that they suffer less from inflation than sectors at the far end of the value chain like consumer discretionary. Chart 10 shows how relative performance of the S&P industrials sector is “neither here nor there” when examining inflationary spikes. Chart 10Inflation & Industrials Equities Inflation & Industrials Equities Inflation & Industrials Equities However, taking a closer look, we do note a shorter-term pattern that unfolds within every inflationary period. The S&P industrials index outperforms in the early stages of an inflationary spike, but then gives up its gains as inflation re-accelerates. There is an intuitive explanation for this dynamic. As deflation recedes giving way to inflation, industrial stocks are able to pass on the initial price increases to their customers thus preserving margins and profits. But as inflation persists, the fact that industrials companies are located in the middle of the economic value chain becomes a headwind as they are no longer able to pass on costs increases, which in turn gets reflected in falling relative stock prices. Bottom Line: Keep the S&P industrials index in the overweight basket early on into an inflationary spike, but do not overstay your welcome as inflation endures. Positioning For True Inflation: S&P Materials Typically, inflationary pressures first manifest themselves in higher raw material costs as rising demand from increased economic growth outpaces supply, benefiting materials equities. At the same time, the fact that materials stocks are the first link in the economic value chain allows them to efficiently pass on price increases, whereas other sectors at the end of the value chain like S&P consumer discretionary typically have the hardest time doing so (Chart 11). Chart 11Inflation & Materials Equities Inflation & Materials Equities Inflation & Materials Equities The current deflationary environment has proven rocky for the S&P materials sector as it sits at the second lowest level in history following the dotcom-formed “Mariana Trench”. Should our forecast for an inflationary revival prove accurate, materials producers will be prime beneficiaries with ample upside potential. The mean relative share price ratio during the previous inflationary cycle (1960-1996) is 0.25. Today, materials are sitting at the 0.12 mark, which makes a 100%+ rise a reasonable structural forecast. Bottom Line: Materials are a secular buy in an inflationary world. Positioning For True Inflation: S&P Technology On the surface, the S&P technology sector appears to be a textbook candidate to short during inflation, but empirical data disagrees with the theory. The top panel of Chart 12 shows that there have only been two clean periods when tech underperformed during true inflationary periods (1974-1976 and 1987-1990). On the other hand, in 1977 – the year that had a very significant inflationary spike – technology stocks managed to outpace the broad market by a wide margin. Chart 12Inflation & Technology Equities Inflation & Technology Equities Inflation & Technology Equities The reason for such inconsistent performance is due to the fact that the sector is sensitive to two opposing forces: multiple contraction and real economic growth. It is well-know that currently technology stocks represent the longest duration sector within the S&P 500, but they also enjoy inelastic demand profile. In other words, corporations cannot put their guard down and fully trim CAPEX and R&D expenses even during recessions because if they do, their competition will steam roll ahead. The same holds for the consumer sector. While some tech gadgets are luxury goods, consumers cannot simply postpone their PC, phone, and software related expenses as those are necessity goods. In short, the S&P technology index is not a pure-play cyclical sector as inelastic demand profile for its goods from other economic agents gives the sector some inflation-proof properties. Given that the upcoming inflationary impulse will be fiscal-driven, we would not rush to put tech stocks in the underweight basket. Instead, we opt to stick with a neutral allocation to underscore this tug of war effect between the two forces. Bottom Line: Relative technology performance in an inflationary world will depend on whether real economic growth can compensate for multiple contraction. Stick with a benchmark allocation. So What? In this Special Report we examined how investors should be positioned for true inflation rather than reflation. Some of the key differences are the following: financials switch from being a buy during reflation to a sell during true inflation, industrials are flat when looking at the entire inflationary spike, but they outperform in the early innings and underperform in the later stages of inflation, and finally technology is not a clear underperformer as this sector is caught between two opposing forces. Now circling back to our structural inflationary view, while it will take time for the current deflationary megatrend to make a full U-turn, the incoming post-recessionary spike driven by fiscal spending and heating up of the US economy will make for the right environment to test whether last century’s inflationary correlations will still hold. Our portfolio is appropriately positioned to test this hypothesis with an overweight toward inflationary winners and a neutral weight in inflationary losers (Table 2). As a reminder we have the S&P financials sector on downgrade alert. Table 2Current Portfolio Positioning Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation For completion purposes, Chart A1 in the Appendix on the next page also provides historical performance for defensive GICS1 sectors during true inflationary periods. Bottom Line: Investors should overweight true inflationary winners as the incoming CPI flux will unlock excellent value in those sectors.   Appendix Chart A1Appendix Appendix Appendix         Footnotes  

Highlights EM banks will underperform their DM peers in the next six months due to worsening relative NPL dynamics and shrinking net interest margins. EM banks will either continue experiencing rising NPLs and moribund loan demand due to restrictive lending rates or will have to reduce their lending rates, which will considerably shrink their net interest margins. In both scenarios, EM bank profits will be damaged. Besides, EM is facing an unfriendly macro cocktail of booming US growth and a slowing China. This could cause a capital exodus from EM in the coming months depressing EM currencies and precluding many central banks from cutting interest rates proactively. Feature Chart 1EM vs. DM Banks: More Underperformance Ahead EM vs. DM Banks: More Underperformance Ahead EM vs. DM Banks: More Underperformance Ahead We recommend initiating the short EM banks / long DM banks strategy. There has been a major technical breakdown in EM share prices versus DM peers (Chart 1). When discussing EM banks for the purpose of macro analysis, we separate Chinese, Korean and Taiwanese banks from their EM peers. The basis is that the banking systems in China, Korea and Taiwan1 face different cyclical and structural outlooks than in the rest of EM. Bank assets-to-GDP ratios are much more elevated and the monetary and fiscal policies have more flexibility in China, Korea and Taiwan than in EM. Chart 2Fiscal Thrust In EM And DM Fiscal Thrust In EM And DM Fiscal Thrust In EM And DM Reason #1: Higher NPLs In EM Than DM As a result of the pandemic lockdowns, bank NPLs have surged both in EM and DM. However, DM banks have begun to pare down the NPL provisions they had built over the past year. By contrast, NPLs in EM economies will linger due to persisting economic weakness. In fact, EM banks might need to boost their NPL provisions, further eroding their profits. DM policymakers have provided much more fiscal support to their economies than the governments in EM (ex-China, Korea and Taiwan). The fiscal thrust in these EM economies will be negative in 2021 while it is expected to be positive in the US and neutral in the euro area (Chart 2). Chart 3 shows the fiscal thrust across individual EM economies. The fiscal thrusts in Russia and Brazil are the most negative. In EM (ex-China, Korea, Taiwan), the prime lending rates have declined but are still high both in nominal terms (around 10%) and in real terms (6.5%) (Chart 4, top and middle panels). In our opinion, these levels of prime lending rates are restrictive for EM economies and will both inhibit loan demand and undermine debtors’ ability to service debt. Consistently, bank loan growth remains very muted in EM (ex-China, Korea, Taiwan) (Chart 4, bottom panel). Chart 32021 Fiscal Thrust In Individual EM Countries Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks The pandemic is lingering in several developing countries and their vaccination efforts are trailing those of DM. Consequently, the pace and timing of a full economic recovery in EM will lag those in DM. Chart 5 illustrates that retail sales and auto purchases in EM (ex-China, Korea, Taiwan) remain lackluster. Chart 4EM Bank Lending Rates Are Restrictive EM Bank Lending Rates Are Restrictive EM Bank Lending Rates Are Restrictive Chart 5EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster   Reason #2: Net Interest Margin Squeeze For EM Banks EM banks are facing a dilemma. They have a choice between: continuing to experience rising NPLs and moribund loan demand due to restrictive lending rates, which will also undermine bank profits; and/or significantly reducing their lending rates to spur new lending and to help debtors service their loans. In such a case, their net interest margins and profits will shrink. In a nutshell, the fact that borrowers are struggling despite lending rates being much lower than they have been in the past boils down to underlying productivity and return on capital. Both have downshifted considerably in EM (ex-China, Korea, Taiwan) economies. This was true before the pandemic erupted and is also true at present. Chart 6EM Banks: Net Interest Margin And EPS EM Banks: Net Interest Margin And EPS EM Banks: Net Interest Margin And EPS In brief, the only way for EM banks to avoid escalating NPLs is to reduce lending rates. Yet, the latter will erode their net interest margins and depress their profits. Chart 6 demonstrates that net interest rate margins have been an important driver of banks’ EPS growth and they currently point to weaker bank earnings. Notably, there is little room for EM (ex-China, Korea, Taiwan) central banks to cut their policy/short rates. Doing so could trigger a weakness in their currencies at a time when US growth is booming, and US bond yields are under upward pressure. Overall, any decline in prime lending rates will produce a net interest margin squeeze for banks in EM (ex-China, Korea, Taiwan). In China, authorities have been clear that they expect banks to reduce their lending rates for SMEs even though the central bank does not plan on cutting short-term rates. Such pressure on mainland banks will intensify as growth slows in H2 2021. Hence, Chinese banks are also experiencing a net interest margin contraction. Reason #3: An Unfriendly Macro Cocktail For EM Our major global theme for 2021 is an economic boom in the US and a slowdown in China. Such a global macro dynamic warrants a rebound in the US dollar and a pullback in commodities prices. The US economy will be booming in H2 2021 facilitated by the general reopening of the economy, massive fiscal stimulus, rising employment and income growth as well as the release of pent-up demand for services. The Chinese economy is about to decelerate, as foretold by the rollover in money and credit impulses (Chart 7). China’s slowdown will lead to a decline in commodities prices and EM currencies (Chart 8). Chart 7China Is Set To Slow Down China Is Set To Slow Down China Is Set To Slow Down Chart 8Commodities And EM Currencies Are At Risk Commodities And EM Currencies Are At Risk Commodities And EM Currencies Are At Risk   Finally, one of the best leading indicators for EM EPS has been China’s narrow money growth. Chart 9 demonstrates that the latest rollover in Chinese narrow money growth heralds a slowdown in EM EPS later this year. Chart 9China's Narrow Money Heralds EM EPS Slowdown In H2 China's Narrow Money Heralds EM EPS Slowdown In H2 China's Narrow Money Heralds EM EPS Slowdown In H2 EM’s business cycle is very sensitive to China’s growth because many emerging economies sell to China as much if not more than to the US. An impending slowdown in China will cause a meaningful setback in commodities prices and will depress terms of trade for many EM (ex-China, Korea, Taiwan) economies. In turn, a booming US economy will herald higher US bond yields. Together, these dynamics will likely precipitate a rebound in the US dollar. In sum, such a macro cocktail could cause a capital exodus from EM in the coming months, depressing EM currencies and precluding many central banks from cutting interest rates proactively. As a result, EM local currency bond yields will not fall much, especially in vulnerable EM countries. Chart 10EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise Chart 10 demonstrates that the rise in EM local currency yields (shown inverted on the chart) is typically negative for EM (ex-China, Korea, Taiwan) bank stocks. This is opposite to the dynamics in the US and in Europe where bank share prices rally when bond yields rise. Reason #4: Chinese Bank Stocks Remain A Value Trap Market cap of Chinese bank stocks represents 25% of the MSCI EM bank index. Hence, the performance of Chinese bank share prices contributes significantly to the MSCI EM bank stock index. Chinese commercial banks’ assets have expanded 1.5-fold since early 2009 (Chart 11). The overwhelming part of this expansion has been driven by loan origination, purchases of corporate bonds and various claims on local governments and their affiliated vehicles.  We have written often and at length that there is no link between trends in bank assets and national or household savings. Critically, banks do not intermediate deposits into loans or savings into credit. This holds true in all countries around the world. Following such an epic credit boom in China since 2009, one would typically expect creditors in general and banks in particular to undertake a profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, Chinese banks have not yet sufficiently cleansed their balance sheets and carry a lot of non-recognized bad loans/assets. Investors doubt the quality of the banks’ books. As a result, Chinese banks’ share prices have been in limbo over the last ten years (Chart 12, top panel). Chart 11Chinese Bank Assets: An Epic Boom Chinese Bank Assets: An Epic Boom Chinese Bank Assets: An Epic Boom Chart 12Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan   Provided that this issue of mainland bank asset quality is well known, the government will not allow a full-fledged banking crisis. However, authorities will also not recapitalize banks without current shareholders experiencing losses. Overall, Chinese bank share prices might share the fate of Japanese bank stocks. The latter has been in a secular bear market even though Japan has never had an acute credit crisis (Chart 12, second panel). In a nutshell, Korean and Taiwanese bank share prices have also delivered very poor returns over the past 20 years, even though these banks have not had an acute crisis and the credit-to-GDP ratios in these economies have been rising (Chart 12, third and fourth panels). The upshot is that a rising credit penetration is not sufficient to produce value for bank shareholders. The quality of credit assets, profit margins and the starting points of both equity valuation and bank capital adequacy matter for forward returns on bank stocks. A Word On Bank Stock Valuations Chart 13EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio Even though Chinese bank stocks trade at very low multiples – the price-to-book value (PBV) ratio is presently 0.6, the latter represents a value trap. For comparison, the PBV ratio is 0.5 in Korea and 1.2 in Taiwan. Excluding China, Korea and Taiwan, the EM bank PBV ratio is well below its historical mean (Chart 13). However, this aggregate conceals the wide disparity among EM banks. Chart 14 plots banks’ return on equity (RoE) over the past 12 months on the X-axis and their PBV ratio on the Y-axis. There is a clear positive correlation between RoE and the PBV ratio.   Chart 14A Comparative Valuation Matrix For Global Bank Stocks Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks Combining bank equity valuations and country macro fundamentals, within the EM bank space we favor banks in India, Mexico, Korea, the Czech Republic, Russia (barring a major military conflict in Ukraine) and Singapore. On the other hand, the most vulnerable are bank share prices in Brazil, Peru, Turkey, the Philippines, Malaysia and Indonesia. Concerning Chinese banks, we continue advocating the long large banks/short small and medium bank stocks strategy. The rationale is that a lot of bad news is already discounted in large bank stocks and little in listed small and medium bank stocks. In particular, the PBV ratio is 0.7 for large banks and 1.3 for small and medium banks. More so than large banks, small and medium banks are at risk from the new asset management regulation that will be implemented by the end of this year. Investment Recommendations We initiate a short EM banks / long DM banks position. This is a medium-term strategy for the next six months. This strategy is consistent with our tactical underweight in EM stocks versus DM stocks that we recommended on March 25. From a structural perspective, we continue recommending a neutral allocation to EM within a global equity portfolio. Today we are also publishing a report on India that highlights near-term downside risks to this bourse due to surging COVID-19 cases. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential super-spreader events. As a result, we recommend that asset allocators with less tolerance for volatility tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Chart 15Move Peruvian Stocks From Neutral To Underweight Move Peruvian Stocks From Neutral To Underweight Move Peruvian Stocks From Neutral To Underweight Finally, Peruvian bank stocks have been plunging on the heels of left-wing candidate Pedro Castillo lead in the presidential electionspolls ahead of the second round on June 6th. Chart 15 shows that surging NPLs (shown inverted) herald more downside in bank share prices. Consequently, in the context of political uncertainty, rising NPLs and a potential decline in metal prices, we are downgrading Peruvian equities from neutral to underweight. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 We refer to Taiwan (Province of China) herein in the report as Taiwan.   Equities Recommendations Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks Currencies, Credit And Fixed-Income Recommendations

Set A Downgrade Alert On Financials Set A Downgrade Alert On Financials One week following the Pfizer/BioNTech vaccine efficacy news, we boosted the S&P financials sector to overweight and since then financials have bested the SPX by 13%, an impressive run. However, the euphoria surrounding the reopening trade, which the bond market’s sell off best captures, has hit a wall of late, and not only have yields settled lower, but financials stocks have also come off the boil (top panel). Given that financials equities represent the nervous system of the US economy this soft-patch raises the question: is this a genuine pause for breath or have relative share prices already discounted all the good news including the third mega fiscal package announced over the past four months? What is slightly unnerving is that other high frequency economic reopening indicators also wave yellow flags. The value/growth style bias has fallen to a level consistent with a 10-year US Treasury yield near the early January 1.10% breakout level, the small/large size bias has made a mini lamda (Λ) formation and even our long “Back-To-Work”/short “COVID-19 Winners” pair trade is grinding lower (second, third & bottom panels). While the jury is still out, we want to lean on the side of caution and protect handsome profits accrued to our portfolio since the mid-November inception, and thus put the sector on our downgrade watch list and set a trailing stop at the 10% return mark. Bottom Line: Put the S&P financials sector on downgrade alert and set a trailing stop at the 10% return mark. Stay tuned.  

Feature The selloff in Chinese stocks since mid-February reflects a rollover in earnings growth and multiples. Lofty valuations in Chinese equities driven by last year’s massive stimulus means that stock prices are vulnerable to any pullback in policy supports (Chart 1A and 1B). Chart 1AGrowth In Chinese Investable Earnings And Multiple Expansions Has Rolled Over Growth In Chinese Investable Earnings And Multiple Expansions Has Rolled Over Growth In Chinese Investable Earnings And Multiple Expansions Has Rolled Over Chart 1BEarnings Outlook Still Looks Promising In The Onshore Market, But May Soon Peak Earnings Outlook Still Looks Promising In The Onshore Market, But May Soon Peak Earnings Outlook Still Looks Promising In The Onshore Market, But May Soon Peak After diverging in the past seven to eight months, Chinese stocks have started to gravitate towards deteriorating monetary conditions index. The market may be beginning to price in a peak in economic as well as corporate profit growth (Chart 2). Defensive stocks in China’s onshore and offshore equity markets have also outperformed cyclicals since February, which confirms that investors expect earnings growth will slow in the coming months (Chart 3). A tighter monetary policy stance, coupled with increased regulations targeting the real estate, banking, and tech sectors have further dampened investors’ appetite for Chinese stocks. Chart 2A-Share Prices Start To Gravitate Towards Tightening Monetary Conditions A-Share Prices Start To Gravitate Towards Tightening Monetary Conditions A-Share Prices Start To Gravitate Towards Tightening Monetary Conditions Chart 3Defensives Have Prevailed Over Cyclicals In Both Onshore And Offshore Markets Defensives Have Prevailed Over Cyclicals In Both Onshore And Offshore Markets Defensives Have Prevailed Over Cyclicals In Both Onshore And Offshore Markets The official PMIs bounced back smartly in March following three consecutive months of decline. However, the strong PMI readings do not change our view that the speed of China’s economic recovery is near its zenith. PMIs in the first two months of the year are typically lower due to the Lunar New Year (LNY), and the improvement in March’s PMI did not exceed seasonal rebounds experienced in previous years. Weakening fixed-asset investments also indicate that economic activity is moderating. We remain cautious on the 6 to 12-month outlook for Chinese stocks, in both absolute and relative terms. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     China’s NBS manufacturing and non-manufacturing PMIs in March beat market expectations with sharp rebounds after moderating in the previous three months. The improvement in the PMIs will likely provide authorities with confidence to stay the course on policy normalization. The methodology calculating PMI indexes reflects the net reported improvement in business activities relative to the previous month and there was a notable decline in PMIs in February, due to the LNY holiday and travel restrictions related to the spread of COVID-19.  Additionally, the average reading of China’s official composite PMI in Q1 this year was 2.2 percentage points lower than in Q4 last year and weaker than the Q1 PMI figures in most of the pre-pandemic years. Moreover, Chinese Caixin manufacturing PMI, which focuses on smaller and private corporates, declined further in March as it continued its downward trend started in December 2020. Chart 4Q1 PMIs Slowed By More Than Seasonal Factors Q1 PMIs Slowed By More Than Seasonal Factors Q1 PMIs Slowed By More Than Seasonal Factors Chart 5Caixin PMI Shows Further Deterioration Among Private-Sector Manufacturers Caixin PMI Shows Further Deterioration Among Private-Sector Manufacturers Caixin PMI Shows Further Deterioration Among Private-Sector Manufacturers Growth in credit expansions in February was better than expected, supported by a substantial increase in corporates’ demand for medium- and long-term loans. Travel restrictions during this year’s LNY led to a shorter holiday, a faster resumption in manufacturing activity after the break and stronger credit demand in February. China’s Monetary Policy Committee meeting last week reiterated the authorities’ hawkish policy tone and removed dovish language prevalent in last month’s National People’s Congress, such as “maintaining the consistency, stability, and sustainability in monetary policy” and “not making a sudden turn in policymaking.” Given the strong headline economic and credit data in January and February, the authorities will be unlikely to slow normalizing monetary policy. Therefore, the risk of a policy-tightening overshoot remains high. The PBoC has continued to drain net liquidity in the interbank system since early this year, evidenced by falling excess reserves at the central bank. Excess reserves normally lead the credit impulse by about six months, signaling that the latter will continue to decelerate in the months ahead. In turn, the credit impulse normally leads the business cycle by six to nine months, meaning that China’s cyclical economic recovery will likely peak in the first half of 2021. Chart 6Corporates Demand For Longer-Term Bank Loans Resumed Their Upward Trend Early This Year Corporates Demand For Longer-Term Bank Loans Resumed Their Upward Trend Early This Year Corporates Demand For Longer-Term Bank Loans Resumed Their Upward Trend Early This Year Chart 7Falling Excess Reserves Leads To A Deceleration In Credit And Economic Growth Falling Excess Reserves Leads To A Deceleration In Credit And Economic Growth Falling Excess Reserves Leads To A Deceleration In Credit And Economic Growth Robust industrial activities and improving profitability helped to boost profit growth in January and February. The bounce in producer prices also drove up returns in industrial output, particularly in upstream industries loaded with commodity producers. Nevertheless, weak final demand is limiting the ability of Chinese producers to pass on higher prices to domestic consumers, highlighted in the divergence between Chinese PPI and CPI. In addition, China’s domestic demand for commodities and industrial metals may reach its cyclical peak in mid-2021, following ongoing credit tightening and reduced economic activity. Commodity inventories have surged to historical highs due to soaring imports (which far exceeded consumption) during 2H20. Inventory destocking pressures will weigh on commodity prices with China’s domestic demand reaching its cyclical peak. Disinflation/deflation pressures may re-emerge in 2H21, which will pose downside risks to China’s industrial profits. Chart 8Industrials Posted A Strong Rebound In The First Two Months of 2021 Industrials Posted A Strong Rebound In The First Two Months of 2021 Industrials Posted A Strong Rebound In The First Two Months of 2021 Chart 9Surging Commodity Prices Helped To Boost Upstream Industry Profits Surging Commodity Prices Helped To Boost Upstream Industry Profits Surging Commodity Prices Helped To Boost Upstream Industry Profits Chart 10Domestic Final Demand Remains Sluggish Domestic Final Demand Remains Sluggish Domestic Final Demand Remains Sluggish Chart 11Decelerating Chinese Credit Growth Poses Downside Risks To Global Commodity Prices Decelerating Chinese Credit Growth Poses Downside Risks To Global Commodity Prices Decelerating Chinese Credit Growth Poses Downside Risks To Global Commodity Prices Chart 12Chinas Raw Material Inventory Restocking Cycle May Be Near A Cyclical Peak Chinas Raw Material Inventory Restocking Cycle May Be Near A Cyclical Peak Chinas Raw Material Inventory Restocking Cycle May Be Near A Cyclical Peak Chart 13Real Estate And Infrastructure Investment Losing Steam In 2021 Real Estate And Infrastructure Investment Losing Steam In 2021 Real Estate And Infrastructure Investment Losing Steam In 2021 Investments in infrastructure and real estate drove China’s economic recovery in the second half of 2020. However, growth momentum in both sectors has slowed because of retreating government spending in infrastructure and tightening regulations in the property sector. Both home sales and housing prices, especially in tier-one cities, rose significantly in January-February this year, deepening authorities’ concerns over bubble risks in the property market. The share of mortgages, deposits and advanced payments as a source of funds for property developers reached an all-time high in February. Following the LNY, the authorities introduced a slew of new restrictions on the housing market to curb excessive demand. These were in addition to placing limits on bank lending to both property developers and household mortgages. All of these measures will weigh on housing supply and demand, and the impact is already evident in falling land purchases and housing starts. At the same time, property developers are rushing to complete existing projects. The tighter regulations on real estate financing will likely weaken growth in real estate investment and construction activities in the second half of this year. Chart 14Housing Prices In Top-Tier Cities Have Been On A Tear … Housing Prices In Top-Tier Cities Have Been On A Tear Housing Prices In Top-Tier Cities Have Been On A Tear Chart 15… But Bank Lending To Developers And Mortgage Loans Continue Downward Trend But Bank Lending To Developers And Mortgage Loans Continue Downward Trend But Bank Lending To Developers And Mortgage Loans Continue Downward Trend Chart 16Property Developers Are Rushing To Sell And Complete Existing Projects Property Developers Are Rushing To Sell And Complete Existing Projects Property Developers Are Rushing To Sell And Complete Existing Projects Chart 17Forward-Looking Indicators Suggest A Slowdown In Housing And Construction Activities Forward-Looking Indicators Suggest A Slowdown In Housing And Construction Activities Forward-Looking Indicators Suggest A Slowdown In Housing And Construction Activities   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes Cyclical Investment Stance Equity Sector Recommendations

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Rates Are Rising Everywhere Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Global Excess Savings Total $3 Trillion Global Excess Savings Total $3 Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Chart 6Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 ...Since This Is As Early As Q3 2021 ...Since This Is As Early As Q3 2021 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing ...With The Possible Exception Of Housing ...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global Economy Chart 18US Growth Already Looks Strong... US Growth Already Looks Strong... US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening China Is Risking Overtightening China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places Financials And Tech: Trading Places Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Stay Long TIPS Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Limited Upside For Oil From Here Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Turning More Positive On Private Equity Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Is Perfection Priced In? Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? China Slowing Again? China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

Highlights Extremely accommodative fiscal policy and a rapid pace of vaccination puts the US on track to close its output gap by the end of the year. The situation is different in Europe, and the euro area economy will likely continue to underperform the US until at least the summer. Investors are now unusually more hawkish than the Fed, whose caution is driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. The Fed’s rate projections, coupled with the extraordinary size of the American Rescue Plan, have stoked investor concerns about a significant rise in inflation. For inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. We expect a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. We recommend that investors maintain below-benchmark portfolio duration, and overweight US speculative over investment-grade corporate bonds. The fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar over the coming 0-3 months. But over a 6-12 month time horizon, we continue to favor global ex-US vs. US stocks, and expect the dollar to be lower than it is today. A Brighter Light At The End Of The Tunnel Chart I-1Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Over the past 4-6 weeks, the US has continued to make incredible progress in vaccinating its population against COVID-19. Chart I-1 highlights that the pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the US will have vaccinated 90% of its population by the end of September (if it is determined that the vaccine is safe to give to children). And these calculations assume the continuation of a two-dose regime, meaning that the eventual rollout of Johnson & Johnson's Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further. The situation is clearly different in Europe. The vaccination progress in several European countries is woefully behind that of the US and the UK (Chart I-2), and per capita cases in the euro area have again risen significantly above that of the US (Chart I-3). This reality motivated last week’s news that the European Union is reportedly planning on banning exports of the AstraZeneca vaccine for a period of time, as European policymakers grow increasingly concerned about the potential economic consequences of lengthened or additional pandemic control measures over the coming few months. Chart I-2Europe Is Badly Lagging The Vaccine Race… April 2021 April 2021 There was at least some positive economic news from Europe this month, as reflected by the flash manufacturing and services PMIs (Chart I-4). The euro area manufacturing PMI surpassed that of the US this month, reflecting that the prospects for goods-producing companies in Europe remain solidly linked to the strong global manufacturing cycle. Services, on the other hand, have been the weak spot in Europe, having remained below the boom/bust line since last summer (in contrast to the US). The March services PMI highlighted that this gap is now starting to narrow, although the euro area economy will likely continue to underperform the US until at least the summer. Chart I-3...And It Is Starting To Show ...And It Is Starting To Show ...And It Is Starting To Show Chart I-4Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go   The underperformance of the European services sector over the past nine months has been due in part to more severe pandemic control measures, but also a comparatively timid fiscal policy. The IMF’s October Fiscal Monitor highlighted that the US had provided roughly eight percentage points more of GDP in above-the-line fiscal measures versus the European Union as a whole, and that was before the US December 2020 relief bill and this month’s $1.9 trillion American Rescue Plan (ARP) act were passed. The CBO estimates that the ARP will result in about US$1 trillion in outlays in 2021, which is roughly 5% of nominal GDP. Consequently, Chart I-5 highlights that consensus expectations now suggest that the output gap will be marginally positive by the end of the year, with the Fed’s most recent forecast implying that real GDP will be more than 1% above the CBO’s estimate of potential output. Chart I-5The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The Fed Versus The Market Despite this, the Fed held pat during this month’s FOMC meeting and did not validate market expectations of rate hikes beginning in early 2023. Chart I-6 highlights the Fed funds rate path over the coming years as implied by the OIS curve, alongside the Fed’s median projection of the Fed funds rate. This means that investors are now more hawkish than the Fed, which is the opposite of what has typically prevailed since the global financial crisis. Chart I-6The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed Fed Chair Jerome Powell implied during the March 17 press conference that some FOMC participants were unwilling to change their projections for the path of interest rates based purely on a forecast, which argues that the median dot in the Fed’s “dot plot” will shift higher in the second half of the year if participants’ growth and inflation forecasts come to fruition. But Charts I-7A and I-7B suggest that the Fed’s caution is also driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. Chart I-7AA Positive Output Gap Implies… April 2021 April 2021 Chart I-7B…An Unemployment Rate Below NAIRU April 2021 April 2021   The charts highlight the historical relationship between the output gap and the deviation of NAIRU from the unemployment rate, from 2000 and 2010. In both cases, the charts show that the unemployment rate would be below the CBO’s estimate of NAIRU at the end of this year (roughly 4.5%) given the CBO’s estimate for potential (i.e. full employment) GDP and the Fed's forecast for growth. However, the Fed is forecasting that the unemployment rate will essentially be at NAIRU, which is itself above the Fed’s longer-run unemployment rate projection of 4%. As such, the Fed does not see the unemployment rate falling to “full employment” levels this year, a precondition for the onset of rate normalization. Investors should note that the relationships shown in Charts I-7A and I-7B suggest that the unemployment rate will be closer to 3-3.5% at the end of this year if the Fed’s growth forecast is correct, which would constitute full employment based on the Fed’s 4% unemployment rate target. The difference between a 3-3.5% unemployment rate and the Fed’s estimate of 4.5% translates to a gap of roughly 1.5-2.5 million jobs at the end of this year, which underscores that the Fed expects either a significant shift in temporary to permanent unemployment or an influx of unemployed workers back into the labor force who don’t quickly find jobs once social distancing ends and pandemic restrictions are no longer required. Chart I-8The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised There are three possible circumstances that would resolve this seeming contradiction. The first is that the Fed’s estimate for growth this year is simply too high, and that the output gap will be close to zero at the end of the year (i.e., more in line with consensus market expectations). The second is that the CBO is understating the level of GDP that is consistent with full employment, namely that potential GDP is higher than what they currently project. But Chart I-8 shows that the CBO’s current estimate for potential output at the end of this year is only 0.4% below what it had estimated prior to the pandemic, which is smaller than the positive gap implied by the Fed’s growth estimate for this year (roughly 1.2%). The third possibility is that the Fed is overestimating the extent to which the pandemic will cause permanent damage to the labor market. As we noted in our February report, even once social distancing is no longer required, it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). A gap of 1.5-2.5 million jobs accounts for roughly 10-15% of pre-pandemic employment in retail trade, or 4-7% of the sum of retail trade, leisure & hospitality, and other services. It is possible that permanent job losses or significantly deferred job recovery of this size will occur, but it is far from clear that it will. Were job losses / deferred jobs recovery of this magnitude to not materialize, it would suggest that the US will reach full employment earlier than the Fed is currently projecting, and would significantly increase the odds that the Fed will begin to taper its asset purchases and/or raise interest rates at some point next year – which is earlier than investors currently expect. For Now, Dangerously Above-Target Inflation Is Unlikely Fed projections of a 0% Fed funds rate for the next 2 1/2 years, coupled with the extraordinary size of the American Rescue Plan, have understandably stoked investor concerns about a significant rise in inflation. Larry Summers’ recent interview with Bloomberg was emblematic of the concern, during which he criticized the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 It is true that the Federal Reserve is explicitly aiming to generate a temporary overshoot of inflation relative to its target, the Biden administration’s fiscal plan is legitimately large, and there is a tremendous pool of excess savings that could be deployed later this year once the pandemic is essentially over. Clearly, the risks of overheating must be higher than they have been in the past. But from our perspective, out-of-control inflation over the coming 12-24 months would very likely necessitate one of two things to occur, and possibly both: US consumers decide to spend an overwhelmingly large amount of the excess savings that have been accumulated. Main street expectations for consumer prices rise sharply, prompted by a public discussion about the likelihood of a shifting inflation regime. Our view is rooted in the examination of the modern-day Phillips Curve that we presented in our January report, which considers both the impact of economic/labor market slack and inflation expectations as a driver of actual inflation. The modern-day Phillips Curve posits that expectations act as the trend for inflation, and slack in the economy determines whether actual inflation is above or below that baseline. Chart I-9 highlights that the output gap worked well prior to the global financial crisis at explaining the difference between actual and exponentially-smoothed inflation, the latter acting as a long-history proxy for expectations. Pre-GFC, the chart highlights that there have been only two exceptions to the relationship that concerned the magnitude rather than the direction of inflation. Post-GFC, the relationship deviated substantially, but in a way that implied that actual inflation was too strong during the last expansion, not too weak – particularly during the early phase of the economic recovery. This likely occurred because expectations initially stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation, but ultimately declined due to a persistently negative output gap as well as in response to the 2014 collapse in oil prices (Chart I-10). Chart I-9Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Chart I-10Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Thus, for inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. Chart I-11 highlights that the amount of excess savings that have accumulated as a percentage of GDP does indeed significantly exceed the magnitude of the output gap, but some of those savings have been and will be invested in financial markets (boosting valuation), some will be used to pay down debt, some will eventually be spent on international travel (boosting services imports), and some will likely be permanently held as deposits in anticipation of future tax increases. And while long-term household expectations for prices have risen since the passing of the CARES act last year, the rise has merely unwound the decline that took place following the 2014 oil price collapse (Chart I-12). Chart I-11A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent Chart I-12Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base   For now, this framework points to a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Investment Conclusions Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. While the Fed is likely to shift in a hawkish direction compared with its current projections, it is highly unlikely to become meaningfully more hawkish than current market expectations unless economic growth and the recovery in the labor market is much stronger than the Fed or the market is projecting. In fact, even if the market’s expectations for the first Fed rate hike shift to mid-2022 over the coming several months, Chart I-13 highlights that the impact on the equity market is likely to be minimal unless investors shift up their expectations for the terminal Fed funds rate. The chart presents a fair value estimate for the 10-year Treasury yield based on the OIS-implied path of the Fed funds rate out to December 2024, and assumes that short rates ultimately rise to the Fed’s long-term Fed funds rate projection of 2.5%. The second fair value series assumes that the shape of the OIS curve stays the same, but shifts closer by 6 months. Chart I-13The Market’s Assumed Rate Hike Path And Terminal Rate Are Not Threatening For Stocks April 2021 April 2021 The chart underscores that the 10-year yield will rise to at most between 2-2.2% by the end of the year based on these scenarios. A shift forward in the timing of Fed rate hikes will impact the short end of the curve, but the long end will remain relatively unchanged if terminal rate expectations stay constant and the term premium on long-term bonds remains near zero. These levels would in no way be economically damaging nor threatening to stock market valuation. It is possible, however, that investor expectations for the neutral rate of interest (“r-star”) will shift higher once the pandemic is over, and we explore this risk to stocks in Section 2 of our report. For now, this remains a risk to our view rather than our expectation, but it is likely to remain an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Within fixed income, we recommend that investors maintain below-benchmark portfolio duration even though investors are already pricing in a more hawkish path for the Fed funds rate. First, Chart I-13 highlighted that yields at the long end of the curve are likely to continue to move modestly higher this year even if the projected path for the Fed funds rate remains relatively unchanged. But more importantly, barring a substantially negative development on the health or vaccine front that prolongs the pandemic, the risk appears to be clearly to the upside in terms of the timing of the first Fed rate hike and the terminal Fed funds rate. As such, from a risk-reward perspective, a long duration stance remains unattractive. We would also recommend overweighting US speculative over investment-grade corporate bonds, as spreads are not as historically depressed for the former than the latter (Chart I-14). Finally, in terms of the dimensions of equity market performance and the dollar, we recommend that investors overweight global ex-US equities vs. the US, overweight value vs. growth, overweight cyclicals vs. defensives, and overweight small vs. large caps. We are also bearish on the dollar on a 12-month time horizon. However, there are two caveats that investors should bear in mind. First, global cyclicals versus defensives (especially in equally-weighted terms) as well as small versus large caps have already mostly normalized not just the impact of the pandemic but as well that of the 2018-2019 Trump trade war (Chart I-15). We would expect, at best, modest further gains from both positions this year. Chart I-14Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Chart I-15Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps   Second, the fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar on a 0-3 month time horizon. The US dollar is typically a counter-cyclical currency, but there have been exceptions to that rule. And historically, exceptions have tended to revolve around periods when US growth has been quite strong, as is currently the case (Chart I-16). A continued counter-trend rally in the dollar is thus possible over the course of the next few months, but we would expect USD-EUR to be lower than current levels 12 months from now. Chart I-16A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A counter-trend dollar move could also correspond with a period of US outperformance versus global ex-US, or at a minimum, a period of flat performance when global ex-US stocks would normally outperform. Our China strategists expect that the Chinese credit impulse will decelerate later this year (Chart I-17), which would weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. Chart I-18 highlights that euro area equity underperformance versus the US last year was mostly a tech story, but today there is little difference between the relative performance of euro area stocks overall versus indexes that exclude the broadly-defined technology sector. In both cases, the euro area index is roughly 10% below its US counterpart relative to pre-pandemic levels, which exactly matches the extent to which euro area financials have underperformed. Chart I-17A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform Chart I-18Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform   Euro area financials have demonstrated very poor fundamental performance over the past decade, but they are likely to outperform for some period once the European vaccination campaign gains enough traction to alter the disease’s transmission and hospitalization dynamics. Chart I-19 highlights that euro area bank 12-month forward earnings have further room to recover to pre-pandemic levels than for banks in the US, and Chart I-20 highlights that euro area banks trade at their deepest price-to-book discount versus their US peers since the euro area financial crisis. Chart I-19Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Chart I-20Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US   Thus, while euro area and global ex-US equities may not outperform on the back of rising global stock prices over the coming few months, investors focused on a 6-12 month time horizon should respond by increasing their allocation to European stocks and to further reduce dollar exposure. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst March 31, 2021 Next Report: April 29, 2021 II. R-star, And The Structural Risk To Stocks In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,2 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway April 2021 April 2021 On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have ticked slightly lower from their strongest levels on record. Within a global equity portfolio, US stocks have recently risen versus global ex-US, reflecting a countertrend rise in the US dollar and a lagging vaccination campaign in Europe. We expect a deceleration in the Chinese credit impulse later this year, which will weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. The US 10-Year Treasury yield has risen well above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields could move higher over the cyclical investment horizon. The recent bounce in the US dollar has reflected improved relative US growth expectations, but also previously oversold levels. The dollar may continue to strengthen on a 0-3 month time horizon, but we expect it to be lower in 12 months’ time than it is today. Commodity prices have recovered not just back to pre-pandemic levels, but also back to 2014 levels. This underscores that many commodity prices are extended, and may be due for a breather once the Chinese credit impulse begins to decline. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. This underscores that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Highlights Fiscal stimulus is no longer a free lunch. US mortgage applications are down by 20 percent since the start of February. With rising bond yields now starting to choke private sector borrowing, bond yields are nearing an upper-limit, and even a reversal point. In which case, the tide out of defensives into cyclicals, and growth into value, will be a tide that reverses. New 6-month recommendation: underweight US banks (XLF) versus consumer staples (XLP). Fractal trade shortlist: US banks, bitcoin, ether, and GBP/JPY. Feature Chart of the WeekMortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Why would anybody not get excited about trillions of dollars of fiscal stimulus? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield, it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending has crowded out a dollar of private sector spending. In this case, fiscal stimulus will have no impact on GDP. The fiscal multiplier will be zero. Under some circumstances though, fiscal stimulus does not crowd out the private sector and the fiscal multiplier is extremely high. 2020 was the perfect case in point. As the pandemic gripped the world, much of the private sector was on its knees. Or to be more precise, in lockdown at home, doing nothing, receiving no income, and unwilling and unable to borrow. In such a crisis, the government became the ‘borrower of last resort’. It could, and had to, borrow at will to replace the private sector’s lost income and thereby to stabilise the collapse in demand. With no competition from private sector borrowers for the glut of excess savings, bond yields stayed depressed. Meaning that fiscal stimulus was a free lunch: it had lots of benefit with little cost (Chart I-2). Chart I-2Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Is No Longer A Free Lunch Covid-19 is still with us, and could be with us forever. Yet the economy will adapt and even thrive with structural changes, such as decentralisation, hybrid office/home working, a shift to online shopping, and less international travel. In fact, all these structural changes were underway long before Covid-19. Meaning that the pandemic was the accelerant rather than the cause of what was happening to the economy anyway. As the private sector now gets back on its feet to restructure, spend, and invest accordingly, fiscal stimulus is no longer a free lunch. Fiscal stimulus is most effective when it is not pushing up the bond yield. To repeat, last year’s massive fiscal stimulus was highly effective because it had little impact on the bond yield, so there was no crowding out of private sector borrowing. The markets have fully priced the 2021 stimulus, but not the crowding out. However, the most recent stimulus package has pushed up the bond yield or, at least, is a major culprit for the recent spike in yields. Hence, there will be some crowding out of private sector borrowing. Worryingly, US mortgage applications, for both purchasing and refinancing, are down by 20 percent since the start of February (Chart of the Week and Chart I-3). Chart I-3Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent The resulting choke on private sector borrowing and investment will at least partly negate any putative boost from this fiscal stimulus. The concern is that the markets have fully priced the stimulus, but not the crowding out. Time To Rotate Back In our February 18 report, The Rational Bubble Is Turning Irrational, we warned that high-flying tech stocks were at a point of vulnerability. Specifically, since 2009, the technology sector earnings yield had always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of a ‘rational bubble.’ In February, this envelope was breached, indicating that tech stock valuations were in a new and irrational phase (Chart I-4). Chart I-4The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The warning proved to be prescient. In the second half of February, tech stocks did sell off sharply and entered a technical correction.1 As a result, tech-dominated stock markets such as China and the Netherlands also suffered sharp declines. Proving once again that regional and country stock market performance is nothing more than an extension of sector performance (Chart I-5). Chart I-5As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets But the aggregate stock market has remained more resilient than we expected, and is only modestly down versus its mid-February peak. The reason is that while highly-valued growth stocks suffered the anticipated correction, value stocks continued to advance (Chart I-6). Chart I-6Time To Rotate Back Time To Rotate Back Time To Rotate Back We can explain this divergence in terms of the three components of stock market valuation: The bond yield. The additional return or ‘risk premium’ for owning stocks. The expected growth of earnings. Tech and other growth stocks are ‘long-duration’ assets meaning that their earnings are weighted into the distant future. Hence, for growth stocks the relevant valuation comparison is a long-duration bond yield, say the 10-year yield. Whereas for ‘shorter-duration’ value stocks the relevant valuation comparison is a shorter-duration bond yield, say the 2-year yield. Given that the 10-year yield has risen much more than the 2-year yield, the pain has been much more pronounced for growth stock valuations. Turning to the ‘risk premium’ for owning stocks, at ultra-low bond yields the risk premium just moves in tandem with the bond yield. Hence, as the 10-year yield has spiked, the combination of a rising yield plus a rising risk premium has doubled the pain for growth stock valuations. For a detailed explanation of this dynamic please see our February 18 report. Regarding the expected growth of earnings, the market believes that stimulus is much more beneficial for economically sensitive value stocks than for economically insensitive growth stocks. But now that we are at the point where rising bond yields are starting to choke private demand, the rise in bond yields is nearing a limit, and even a reversal point. In which case, the strong tide out of defensives into cyclicals will also be a tide that reverses. On this basis, and supported by the strong technical arguments in the next section, we are opening a new 6-month position: Underweight US banks versus US consumer staples, expressed as underweight XLF versus XLP. US Banks, Bitcoin, Ether, And The Pound This week we have identified susceptibilities to countertrend moves in three areas. The bullish groupthink in US banks is at an extreme. First, based on its fragile fractal structure, the (bullish) groupthink in US banks versus consumer staples is at an extreme approaching February 2016 (bearish), December 2016 (bullish), and March 2020 (bearish). All these previous extremes in fragility proved to be turning points in relative performance. If this proves true again, the next six months could see a reversal of US bank outperformance (Chart I-7). Chart I-7The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme Second, we are extremely bullish on the structural prospects for cryptocurrencies, and are preparing a report detailing the compelling investment case. Look out for it. That said, the composite fractal structures of both bitcoin and ethereum indicate that they are technically very overbought (Chart I-8 and Chart I-9). Accordingly, we are hoping for pullbacks that provide better strategic entry points for bitcoin at $40,000, and for ethereum at $1300. Chart I-8Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Chart I-9Ethereum Is Technically Overbought Ethereum Is Technically Overbought Ethereum Is Technically Overbought Third, the UK’s Covid-19 vaccination program was one of the fastest out of the blocks. As the vaccination rate quickly rose to over half the adult population (based on at least one vaccination dose), the pound was a major beneficiary. But now, the UK vaccination program is facing the hurdle of reduced supplies. Additionally, there is the danger that the third wave of infections in Continental Europe washes onto the shores of Britain. Hence, the recent strong rally in the pound is susceptible to a countertrend reversal (Chart 10). This week’s recommended trade is short GBP/JPY setting the profit target and symmetrical stop-loss at 2.2 percent. Chart I-10The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 A technical correction is defined as a 10 percent price decline. Fractal Trading System Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Asset Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Equity Market Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​​​