Inflation/Deflation

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 Duration: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Corporate Bonds: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Disposable personal income fell in February compared to January, but it has risen massively since last year’s passage of the CARES act. The large pool of accumulated household savings will help drive economic growth as the pandemic recedes. Feature There is widespread anticipation that the economic recovery is about to kick into high gear. To us, this anticipation seems rather well founded. The United States’ vaccination roll-out is proceeding quickly and the federal government is pitching in with a tsunami of fiscal support. But it’s important to acknowledge that this positive outlook is still a forecast, one that has not yet been validated by hard economic data. The risk for investors is obvious. Market prices have already moved to price-in a significant amount of economic optimism and they are vulnerable in a situation where that optimism doesn’t pan out. In this week’s report we look at how much economic optimism is already discounted in both the Treasury and corporate bond markets. We conclude that the most likely scenario is one where the economic data are strong enough to validate current pricing in both markets. Investors should keep portfolio duration below-benchmark and continue to favor spread product over Treasuries, with a down-in-quality bias. Optimism In The Treasury Market The most obvious way to illustrate the economic optimism currently embedded in Treasury securities is to look at the rate hike expectations priced into the yield curve relative to the Fed’s own projections (Chart 1). The market is currently looking for four 25 basis point rate hikes by the end of 2023 while only seven out of 18 FOMC participants expect any hikes at all by then. Chart 1Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed We addressed the wide divergence between market and FOMC expectations in last week’s report.1 We noted that the main reason for the divergence is that while the market is focused on expectations for rapid economic growth the Fed is making a concerted effort to rely only on hard economic data. This sentiment was echoed by Fed Governor Lael Brainard in a speech last week:2 The focus on achieved outcomes rather than the anticipated outlook is central to the Committee’s guidance regarding both asset purchases and the policy rate. The emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than preemptive at this stage in the recovery. The upshot of the Fed’s excessively cautious approach is that its interest rate projections will move toward the market’s as the hard economic data strengthen during the next 6-12 months, keeping the bond bear market intact. As evidence for this view, consider that the US Economic Surprise Index remains at an extremely high level, consistent with a rising 10-year Treasury yield (Chart 2). Further, 12-month core inflation rates are poised to jump significantly during the next two months as the weak monthly prints from March and April 2020 fall out of the 12-month sample (Chart 3). Then, pipeline pressures in both the goods and service sectors will ensure that inflation remains relatively high for the balance of the year (Chart 3, bottom panel).3   Chart 2Data Surprises Remain Positive Data Surprises Remain Positive Data Surprises Remain Positive Chart 3Inflation About To Jump Inflation About To Jump Inflation About To Jump Finally, the hard economic data still do not reflect the truly massive amount of fiscal stimulus that is about to hit the US economy. Chart 4 illustrates how large last year’s fiscal stimulus was compared to what was seen during recent recessions, and this chart does not yet incorporate the recently passed $1.9 trillion American Rescue Plan (~8.7% of GDP) or the second infrastructure focused reconciliation bill that is likely to pass this fall. Our political strategists expect 2021’s second budget bill to be similar in size to the American Rescue Plan though tax hikes will also be included and, due to the infrastructure-focused nature of the bill, the spending will be more spread out over a number of years.4  Chart 4The Era Of Big Government Is Back That Uneasy Feeling That Uneasy Feeling Bottom Line: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration.  Optimism In The Corporate Bond Market Chart 5What's Priced In Junk Spreads? What's Priced In Junk Spreads? What's Priced In Junk Spreads? The way we assess the amount of economic optimism baked into the corporate bond market is to calculate the 12-month default rate that is implied by the current High-Yield Index spread (Chart 5). We need to make a few assumptions to do this. First, we assume that investors require an excess spread of at least 100 bps from the index after subtracting 12-month default losses. In past research, we’ve noted that High-Yield has a strong track record of outperforming duration-matched Treasuries when the realized excess spread is above 100 bps. High-Yield underperforms Treasuries more often than it outperforms when the realized excess spread is below 100 bps.5 Second, we must assume a recovery rate for defaulted bonds. The 12-month recovery rate tends to fluctuate between 20% and 60%, with higher levels seen when the default rate is low and lower levels when the default rate is high (Chart 5, bottom panel). For this week’s analysis, we assume a range of recovery rates, from 20% to 50%, though we expect the recovery rate to be closer to the top-end of that range during the next 12 months, given our expectations for a rapid economic recovery. With these assumptions in mind, we calculate that the High-Yield Index is fairly priced for a default rate between 2.8% and 4.5% for the next 12 months (Chart 5, panel 2). If the default rate falls into that range, or below, then we would expect High-Yield bonds (and corporate credit more generally) to outperform a duration-matched position in Treasuries. If the default rate comes in above 4.5%, then we would expect Treasuries to beat High-Yield. To figure out whether the default rate will meet the market’s expectations, we turn to a simple model of the 12-month speculative grade default rate that is based on nonfinancial corporate sector gross leverage (aka total debt over pre-tax profits) and C&I lending standards (Chart 6). If we make forecasts for nonfinancial corporate 12-month debt growth and pre-tax profit growth, we can let the model tell us what default rate to anticipate. Chart 6Default Rate Model Default Rate Model Default Rate Model Debt Growth Expectations We expect corporate debt growth to be quite weak during the next 12 months (Chart 7). This is mainly because firms raised a huge amount of debt last spring when the Fed and federal government made it very attractive to do so. Now, we are emerging from a recession and the nonfinancial corporate sector already holds an elevated cash balance (Chart 7, bottom panel). Debt growth was also essentially zero during the past six months, and very low (or even negative) debt growth is a common occurrence right after a peak in the default rate (Chart 7, top 2 panels). It is true that the nonfinancial corporate sector’s Financing Gap – the difference between capital expenditures and retained earnings – is no longer negative (Chart 7, panel 3). But it is also not high enough to suggest that firms need to significantly add debt. Chart 7Debt Growth Will Be Slow Debt Growth Will Be Slow Debt Growth Will Be Slow For our default rate calculations, we assume that corporate debt growth will be between 0% and 8% during the next 12 months. However, our sense is that it will be closer to 0% than to 8%. Profit Growth Expectations Chart 8Profit Growth Will Surge Profit Growth Will Surge Profit Growth Will Surge Our expectation is that profit growth will surge during the next 12 months, as is the typical pattern when the economy emerges from recession. Year-over-year profit growth peaked at 62% in 2002 following the 2001 recession, and it peaked at 51% in 2010 coming out of the Global Financial Crisis (Chart 8). More specifically, if we model nonfinancial corporate sector pre-tax profit growth on real GDP and then assume 6.5% real GDP growth in 2021, in line with the Fed’s median forecast, then we get a forecast for 31% profit growth in 2021. If we use a higher real GDP growth forecast of 10%, in line with our US Political Strategy service's "maximum impact" scenario, then our model forecasts pre-tax profit growth of 40% for 2021.6 Default Rate Expectations Table 1 puts together different estimates for profit growth and debt growth and maps them to a range of 12-month default rate outcomes, as implied by our Default Rate Model. For example, profit growth of 30% and debt growth between 0% and 8% in 2021 maps to a 12-month default rate of between 3.2% and 3.8%. This falls comfortably within the range of 2.8% to 4.5% that is consistent with current market pricing. Table 1Default Rate Scenarios That Uneasy Feeling That Uneasy Feeling In fact, for our model to output a default rate range that is higher than what is priced into junk spreads, we need to assume 2021 profit growth of 20% or less. This is quite far below the estimates we made above based on reasonable forecasts for real GDP. Bottom Line: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Household Income Update Last week’s personal income and spending report showed that disposable household income was lower in February than in January, a decline that is entirely attributable to the fact that the $600 checks to individuals that were part of the December stimulus bill were mostly delivered in January. These “Economic Impact Payments” totaled $138 billion in January and only $8 billion in February. This drop-off of $130 billion almost exactly matches the $128 billion monthly decline seen in disposable personal income. Consumer spending also fell in February compared to January, a result that likely owes a lot to February’s bad weather conditions, particularly the winter storm that caused much of Texas to lose power. Though spending has recovered a lot from last year’s lows, it remains significantly below its pre-COVID trend (Chart 9). In contrast to spending, disposable income has skyrocketed since the pandemic started last March. Chart 10 shows that disposable personal income has increased 8% in the 12 months since COVID struck compared to the 12 months prior. Moreover, it shows that the increase is entirely attributable to fiscal relief. Chart 9Households Have Excess ##br##Savings Households Have Excess Savings Households Have Excess Savings Chart 10Disposable Personal Income Growth And Its Drivers That Uneasy Feeling That Uneasy Feeling The result of below-trend spending and a surge in income is a big jump in the savings rate. The personal savings rate was 13.6% in February, well above its average pre-COVID level (Chart 9, panel 3), as it has been since the pandemic began. This consistently elevated savings rate has led to US households building up a $1.9 trillion buffer of excess savings compared to a pre-pandemic baseline (Chart 9, bottom panel). Perhaps the biggest question for economic growth is whether households will deploy this large pool of savings as the economy re-opens or whether they will continue to hoard it. In this regard, the individual checks that were part of last year’s CARES act are the most likely to be hoarded, as these checks were distributed to all Americans making less than $99,000. The income support provisions in this month’s American Rescue Plan are much more targeted. Only individuals making below $75,000 will receive a $1,400 check and the bill also includes expanded unemployment benefits and a large amount of aid for state & local governments. All in all, we anticipate that a substantial amount of household excess savings will be spent once the vaccination effort has made enough progress that people feel safe venturing out. This will lead to strong economic growth and higher inflation in the second half of 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20210323b.htm 3 For more details on our outlook for core inflation in 2021 please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 4 Please see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com 5 For more details on this excess spread analysis please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 The "maximum impact" scenario assumes that the full amount of authorized outlays from the American Rescue Plan will be spent, with 60% of the outlays spent in FY2021. For more details see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

The inflation/deflation debate has been dominating the news flow and we are compelled to offer our thoughts in two-part series of Special Reports on this widely discussed, but also widely misunderstood topic. Over the past year, we have been inundated with countless questions about our outlook on inflation given the dual monetary and fiscal stimuli that have been ongoing since Covid-19 hit (Chart 1). We take this opportunity to provide detailed answers on everything inflation in this series of Special Reports. Specifically, in this first report we focus on the long-term and structural forces behind US core CPI inflation. We go in depth into the drivers behind the current deflationary trend and also examine what other variables might break that trend in the future. We also try to ignore the medium-term outlook because the inflation story is well-known as the financial media is littered with charts that slice and dice the ISM manufacturing release in every possible way showing that inflation will rebound. Hence, there is no disagreement about the medium-term path for the core CPI inflation. Chart 12020 Stimuli 2020 Stimuli 2020 Stimuli The important question that we look to answer in this Special Report is whether this rebound is a paradigm shift that will push the US into a new era of consistently high (i.e. above 3%/annum) core CPI inflation, or is it a merely counter trend inflationary spike within the broader deflationary megatrend? Laying The Groundwork Before we wrestle with the structural forces behind inflation, first we must get the question of quantitative easing (QE) and its effects on the real economy and inflation out of the way. Undoubtedly, QE is an integral part of any discussion about the real-word and/or financial asset price inflation, and while it tickles the public’s imagination with hyperinflationary fears, the reality is that those fears are largely misplaced (Chart 2). In fact, pundits have established a consensus: “QE only affects the financial economy as it increases bank reserves that can never escape in the real economy. On the other hand, fiscal stimulus affects the real economy and can cause genuine inflation.” There clearly hasn’t been any material inflation since the GFC, so the argument of “QE only affecting the financial economy” appears to be correct, but at closer look there is room for a different interpretation. What is important to understand is that QE is nothing but a tool, sometimes a signaling tool, in the Fed’s arsenal, and like any tool, it can be used in different ways. Chart 2Boogeyman? (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook  The fact that there has not been any material real-world inflation since the housing bubble is neither because QE is structurally deflationary nor because it “cannot touch” the real economy, but because policy makers chose to use the QE tool to rescue creditors (the financial sector) rather than debtors (the real economy) during the GFC. Delving deeper in the Great Recession, the banks were largely undercapitalized with cash accounting for a tiny portion of overall assets and Treasury holdings being at historic lows (Chart 3). The rest of the assets were tied to loans and other risky securities. Once NINJA loans and other subprime loans along with the derivative CLOs/CDOs house of cards began imploding, the banking sector could not stomach the losses owing to the nonexistent cash buffer, and the entire system went into insolvency mode. This is when the Fed stepped in with QE (and the Treasury with TARP in order to recapitalize the banks) to bail out the nervous system of the US economy by boosting reserves and giving freshly printed money to the banks in exchange for their Treasurys, MBS and other risky securities. By providing support to the banking system, the Fed was counterbalancing a deflationary financial industry shutdown (the Richard Koo balance sheet type recession) rather than injecting an inflationary real economic stimulus. As a result, nearly all of the newly created money was stuck in the financial system in the form of new reserves, and as far as the real economy was concerned, no new money entered directly into the real world. This is how the consensus of “QE only affecting the financial economy” was formed, and why we did not observe a long-lasting rise in CPI despite all of the GFC-brought about stimuli. Chart 3Banks Were Well-capitalized Banks Were Well-capitalized Banks Were Well-capitalized Fast-forward to today, and the backdrop could not be more different. The banking sector was well capitalized, so doing an aggressive QE to boost reserves and to stimulate the financial sector would have only provided marginal benefits. The deflationary shock came through the real economy, not the financial economy, meaning that a real (i.e. fiscal) stimulus was needed. Once again, the QE tool comes to the rescue. This time however, QE was also used to finance Main Street stimulus programs as the Fed bought long dated Treasury (and other) securities that pushed interest rates to rock bottom levels and helped facilitate government stimulus spending. Consequently, a more meaningful fraction of QE money reached Main Street and had an effect on the real economy and was not just locked in new reserves. As a reminder, when rates fall to zero and the Fed embarks on QE, the lines between monetary and fiscal policies get blurred. When QE (instead of the foreign or private sectors) is used to facilitate government expenditures, which later on gets distributed into the real economy, QE can provide inflationary support and can reach the real economy. Chart 42008 Versus Today 2008 Versus Today 2008 Versus Today Perhaps the best way to illustrate the difference between 2008 and 2020 is by showing M2 money supply data. The spike in M2 data in 2020 dwarfs the one in 2008; in 2020 QE money reached the real economy and ended up in private sector’s bank accounts (thus contributing to M2 growth), whereas in 2008 QE money was mainly locked in bank reserves. True the money multiplier and M2 money stock velocity are still in hibernation, and were we to see a sustainable inflationary impulses both of these indicators would have to show signs of life (Chart 4). So does this mean that there are grounds for longer-term inflationary concerns since in 2020 QE actually reached the real economy? To answer this question, we now dig deeper into the secular inflation forces and split them in two camps: pro-inflationary and anti-inflationary. Pro-Inflationary Driver #1: The Buenos Aires Consensus Our view since last June has been that fiscal deficits are here to stay as far as the eye can see and the shift from the Washington to the Buenos Aires Consensus1 is a paradigm shift with staying power. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation. Crudely put, as long as fiscal support remains in place (proverbial helicopter drop, Chart 5) after the pandemic is long forgotten it can serve as a meaningful catalyst for structural inflation, instead of being a one-off counterbalancing short-term boost. To reiterate just how much more powerful fiscal spending is outside of a recession, we conduct a labor market analysis and show that a large percentage of the present-day stimulus is being used to counterbalance the deflationary pandemic shock, rather than contributing to driving inflation higher. Table 1 shows our proxy for total payroll losses incurred by America households as a direct result of the pandemic. Our estimate is $501 billion from March 2020 until today. Chart 5Helicopter Checks Helicopter Checks Helicopter Checks The Committee for a Responsible Federal Budget also publishes detailed statistics on the dollar flow of every pandemic stimulus program to a specific economic sector. As of today, US households received $1,400 billion, but some of the stimulus categories simply defer a payment that households still have to make in the future, instead of injecting brand-new money. After stripping those categories out, we arrive to a cleaner number of roughly $1,000 billion – that is how much new money US households received. Next, we subtract our total payroll loss proxy resulting into a net inflow of approximately $500 billion or 2.3% of 2020 US GDP. This is a respectable sum and 2.3% is significant. However, it has one major drawback. The 2.3% GDP stimulus number assumes that every single dollar was actually spent into the real economy, which we know is not true. Table 1The Counterbalancing Effect (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook A recent New York Fed study on how American households used their stimulus money concluded that: “36.4% of the stimulus money was used to boost savings, 34.5% to paydown debt, 25.9% was spent on essentials and non-essentials, and finally the rest of the money (3.2%) was donated”. It is worth noting that this study also looked at the expected spending patterns for the new round of stimulus checks, and the results were generally the same. To obtain a more realistic number of how much of the net $500 billion inflow actually entered the economy, we multiply it by 25.9% (how much money was used on spending according to the NY Fed) and arrive at a better estimate of $130 billion or 0.6% of 2020 US GDP, which is by no means an astronomical number that will shatter into pieces the current deflationary megatrend. This empirical exercise demonstrated how a large percentage of the present-day stimulus is being used to counterbalance the deflationary pandemic shock. However, if our thesis of a Buenos Aires Consensus in which governments spend even outside of recessions pans out, then there will not be the aforementioned counterbalancing effect, and all the fiscal dollars will go straight to contributing to rising inflation until the deflationary megatrend is broken. Pro-Inflationary Driver #2: Demographics In the long run, inflation tends to oscillate alongside a country’s demographics. More specifically, it is the relative size of the three age cohorts (young, working-age, and old) that plays a key role in driving inflation. People who are in the working-age cohort are at their peak productivity, which implies that their contribution to the production of goods and services is greater than the demand for new credit they generate, meaning that they produce a deflationary pull. The opposite is true for the other two age cohorts (the young and the old). Neither one is contributing to the production of goods & services, while both still generate new credit in the economy (for example student loans), and the end result is an inflationary pull. Hence, it is the interplay between these three age cohorts that serves as a structural force behind inflation. To put some numbers behind this conceptual framework, we turn our attention to a paper “The enduring link between demography and inflation” written by Mikael Juselius and Előd Takáts. In the paper, the authors conduct rigorous cross-country analysis and find that indeed, people 30-60 years of age (the working-age cohort) exert deflationary pressure, while the other two cohorts contribute to rising inflation. Chart 6 plots the age-structure effect for the US against inflation. The authors also quantified that over the 40-year period (1970-2010) the increase in the working-age population (due to baby-boomers) has lowered inflationary pressures by almost five percentage points in the US (Chart 7). Meanwhile, by extrapolating the likely path of demographic data by 40 years (2010-2050), the authors observed a shift from deflationary to inflationary age pressure mainly due to the incoming increase in the proportion of the old cohort. Their estimate of the expected pull on inflation in the US will be approximately two and a half percent (Chart 8). Chart 6Demographics Are A Mighty Force Demographics Are A Mighty Force Demographics Are A Mighty Force Chart 7From Deflationary... (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook Chart 8...To Inflationary (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook Going forward, US demographics will be more inflationary than deflationary. Pro-Inflationary Driver #3: De-Globalization The “apex of globalization” or “de-globalization” is our third pro-inflationary driver. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US sustains its aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. Chart 9 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 9The Tide Is Turning The Tide Is Turning The Tide Is Turning De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. And now, President Biden is continuing in Trump’s footsteps. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, first outlined in a 2014 GPS Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future and this should prove inflationary. Pro-Inflationary Driver #4: US Dollar Bear Market The path of least resistance is lower for the US dollar and it represents our final pro-inflationary driver. Chart 10 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the peak was in early-2020. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy (Buenos Aires Consensus) of the current administration that may continue into 2024. Chart 10Time For A Downcycle? Time For A Downcycle? Time For A Downcycle? True, the US dollar remains the global reserve currency, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. While the US Congressional Budget Office (CBO) expects some normalization in the US budget deficit over the next 4 years since the pandemic shock will be over, looking further into the future the CBO forecasts a further reacceleration in deficit spending. Assuming a stable to grinding lower current account deficit in the next several years, the path of least resistance is lower for the currency. BCA’s US dollar model also corroborates the twin deficit message and suggests ample structural downside for the USD (Chart 11).  The apex of globalization will also hurt the greenback in a reflexive manner. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Importantly, the 1970s is an interesting period to examine in more detail. As the Nixon administration floated the greenback this aggravated the inflationary pressures (Chart 12) that were building all along the 1960s when the US adopted the Mutually Assured Destruction Doctrine along with the Cold War space race that eventually saw the US landing on the moon in 1969. Chart 11A Bearish Outlook A Bearish Outlook A Bearish Outlook Chart 12The Greenback In The 1970s The Greenback In The 1970s The Greenback In The 1970s A lower greenback is synonymous with rising commodity and import prices and given that the US is the consumer of last resort (70% PCE), the commodity/import price pendulum will swing from a deflationary to an inflationary force. Anti-Inflationary Driver #1: Technology’s Creative Destruction Schumpeter’s “creative destruction” forces dominate technology companies in general and Silicon Valley in particular, and represent our fist anti-inflationary driver. These creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Chart 13 shows the software sector deflator derived from national accounts, and since the mid-1980s more often than not it has been mired in deflation. US semiconductor prices, computer hardware prices, and almost any tech related category from the PCE, PPI and CPI releases looks more or less the same as software, underscoring that this is a technology sector wide modus operandi. More recently, Uber Technologies and Airbnb, to name a few, continually bring existing capacity online and that adds another layer of deflation forces at work in select industries they operate in. Tack on technology infiltrating finance and soon the extremely opaque health care services industry that comprises almost 20% of US GDP or $4tn and a deflationary impulse will likely reverberate across these large segments of the US economy that have managed to sustain high pricing power over the decades. Chart 13Technological Progress Is Deflationary Technological Progress Is Deflationary Technological Progress Is Deflationary Thus, these creative destruction processes remain alive and well in tech land and will continue to exert deflationary/disinflationary pressure (of the good kind) on the US economy. Anti-Inflationary Driver #2: Income & Wealth Inequality The growing trend in income and wealth inequality is our second anti-inflationary force. We first want to focus on the issue of income inequality as it leads to wealth inequality. Income inequality refers to the distribution of wages and profits generated by the economy. It is the proverbial “share of the pie” that households from different socioeconomic brackets receive. The link with inflation comes through the marginal propensity to save statistic of those different brackets. Lower income households have nearly nonexistent propensity to save as they live paycheck to paycheck. Therefore, any additional income inflow they receive gets immediately syphoned into the real economy. In contrast, the top 10% have a high propensity to save as all of their living expenses are well covered, so any additional income they receive is stashed away into savings and does not enter the real economy. This is why following the Trump’s tax cut that benefitted the top 10% there has not been a durable spike in CPI inflation. The fact that in the US the income share of the top 10% is growing at stratospheric rates at the same as time as the bottom 90% are struggling to cover even a $400 unexpected expense needs no introduction. The exact reasons as to why that happened would require a separate Special Report, but one of the main reasons is the multi-decade suppression of unions, which does not allow employees to bargain effectively for a larger slice of corporate profits. Given that profits are an exact mirror image of labor expenses, it is not surprising that the union movement is being marginalized (Charts 14 & 15). Staying on the topic of inflation, as we already outlined, when the lower and medium socioeconomic brackets receive more income, it does not disappear in the savings accounts, but instead it is redirected into the real economy causing a healthy inflationary uptick. Chart 14No Power = No Money No Power = No Money No Power = No Money Chart 15The Tug Of War The Tug Of War The Tug Of War ​​​​​​​ Chart 16 shows the wealth share of the top 10% of American households on inverted scale. Since the 1920s, inflation and the wealth share of the top 10% has moved in opposite directions. There were two distinct periods when the wealth share of the bottom 90% rose: from the early 1930s until the early 1950s, and from the mid-1960s until the mid-1980s. Both of these periods were accompanied by rising CPI inflation. Chart 16Wealth Equality Is Inflationary Wealth Equality Is Inflationary Wealth Equality Is Inflationary At the same time, when looking at any other period outside of those golden days for the bottom 90%, US inflation was anemic. This empirical evidence further underscores the importance of income and wealth distribution in the economy, and given the current US political and economic realities, we do not expect any material changes in labor dynamics to take root. The top 10% will continue benefitting at the expense of the bottom 90%, which will keep US CPI inflation suppressed. Concluding Thoughts In this Special Report our goal was to look beyond the already known medium term inflation outlook, and present both sides of the argument about the long-term inflation trend. We took a deep dive into six structural forces behind inflation that we identified. Four of those forces were pro-inflationary, while the remaining two were anti-inflationary (Table 2). We also assigned a value on our subjective strength scale for each force. Each value incorporates how quickly a particular force will come to fruition, and how strong it will be over the next 5-to-10 year period. Based on our analysis, we conclude that there are rising odds that the deflationary megatrend has run its course and has reached an inflection point of turning inflationary. Table 2Inflation Dots (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook In the next Special Report from our Tinkering With Inflation series, we will conduct a thought experiment and explore a world in which our forecasts prove to be accurate, and a new inflationary paradigm engulfs the US economy. Under such a backdrop what will the US equity sector winners and losers, especially given the related shift in the stock-to-bond correlation? Stay tuned.   Arseniy Urazov Research Associate ArseniyU@bcaresearch.com   Footnotes 1     Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth.

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite The Global Growth Tax Will Bite The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow Chinese Credit Will Slow Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Deteriorating Surprises Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable Commodities Are Vulnerable Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated Speculators Have Not Capitulated Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates EUR/USD And Chinese Rates EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe Investors Structurally Underweight Europe Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The DEM In The 70s The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial Conditions Easy European Financial Conditions Easy European Financial Conditions Chart 15Make Room For the Euro! Make Room For the Euro! Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It Once Was The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Fixed Income Performance Government Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Corporate Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Equity Performance Major Stock Indices The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Geographic Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Sector Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward  

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, April 1 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Growth outlook: The global economy will rebound over the course of the year, with momentum rotating from the US to the rest of the world. Inflation: Structurally higher inflation is not a near-term risk, even in the US, but could become a major problem by the middle of the decade. Global asset allocation: Investors should continue to overweight equities on a 12-month horizon. Unlike in the year 2000, the equity earnings yield is still well above the bond yield. Equities: Value stocks will maintain their recent outperformance. Investors should favor banks and economically-sensitive cyclical sectors, while overweighting stock markets outside the US. Fixed income: Continue to maintain below average interest-rate duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: While the dollar could strengthen in the near term, it will weaken over a 12-month period. Large budget deficits, a deteriorating balance of payments profile, and an accommodative Fed are all dollar bearish. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Strong Chinese growth will continue to buoy the metals complex. I. Macroeconomic Outlook Global Growth: The US Leads The Way… For Now The global economy should rebound from the pandemic over the remainder of the year. So far, however, it has been a two-speed recovery. Whereas the Bloomberg consensus has US real GDP growing by 4.8% in the first quarter, analysts expect the economies in the Euro area, UK, and Japan to contract by 3.6%, 13.3%, and 5%, respectively. Chart 1Dismantling Of Lockdown Measures Occurring At Varying Pace Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 2US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders Two things explain US growth outperformance. First, the successful launch of the US vaccination campaign has allowed state governments to begin dismantling lockdown measures (Chart 1). Currently, the US has administered 40 vaccine shots for every 100 inhabitants. Among the major economies, only the UK has performed better on the vaccination front (Chart 2). In contrast, parts of continental Europe are still battling a new wave of Covid infections, prompting policymakers there to further tighten social distancing rules. Second, US fiscal policy has been more stimulative than elsewhere (Chart 3). On March 11, President Biden signed the $1.9 trillion American Rescue Plan Act into law. Among other things, the Act provides direct payments to lower- and middle-class households, extends and expands unemployment benefits, and offers aid to state and local governments (Chart 4). Unlike President Trump’s Tax Cuts and Jobs Act, the Democrats’ legislation will raise the incomes of the poor much more than the rich (Chart 5). Chart 3The US Tops The Stimulus Race Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We expect growth leadership to shift from the US to the rest of the world in the second half of the year. Nevertheless, US real GDP in Q4 of 2021 will probably end up 7% above the level of Q4 of 2020, enough to close the output gap. In Section II of this report, we discuss whether this could cause inflation to take off on a sustained basis. We conclude that such an outcome is unlikely for the next two years. However, materially higher inflation is indeed a risk over a longer-term horizon. Chart 4Composition Of The American Rescue Plan Act Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 5Biden’s Package Will Boost The Income Of The Poor More Than The Rich Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   The EU: Recovery After Lockdown The EU will benefit from a cyclical recovery later this year as the vaccination campaign picks up steam. The recent weakness in Europe was concentrated in services (Chart 6). The latest European PMI data shows that the service sector may have turned the corner. As in the US, European households have accumulated significant excess savings. The unleashing of pent-up demand should drive consumption over the remainder of the year (Chart 7). Chart 6For Now, The Service Sector Is Doing Better In The US Than The Euro Area Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 7European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings Meanwhile, the manufacturing sector continues to do well, with the Euro area manufacturing PMI hitting all-time highs in March. Sentiment indices such as the Sentix and ZEW surveys point to further upside for manufacturing activity (Chart 8).   Chart 8Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Fiscal policy should also turn modestly more expansionary. The EU recovery fund will begin disbursing aid in the second quarter. This should allow the southern European economies to maintain more generous levels of fiscal support. It also looks increasingly likely that the Green Party will either lead or join the coalition government in Germany, which could translate into greater spending. UK: Recovering From A One-Two Punch The UK had to shutter its economy late last year due to the emergence of a new, more contagious, strain of the virus. The resulting hit to the economy came on top of a decline in exports to the EU following Brexit. The economic picture will improve over the coming months. Thanks to the speedy vaccination campaign, the government plans to lift the “stay at home” rules on March 29. Most retail, dining, and hospitality businesses are scheduled to reopen on April 12. A strong housing market and the extension of both the furlough schemes and tax holidays should also sustain demand. Japan: More Fiscal Support Needed Like many other countries, Japan had to introduce new lockdown measures in late 2020 after suffering its worst wave of the pandemic. While the number of new cases has dropped dramatically since then, they have edged up again over the past two weeks. Japanese regulations require that vaccines be tested on Japanese people. Prime Minster Yoshihide Suga has promised that vaccine shots will be available to the country’s 36 million seniors by the end of June. However, with less than 1% of the population vaccinated so far, strict social distancing will persist well into the summer. The Japanese government passed a JPY 73 trillion (13.5% of GDP) supplementary budget in December. However, only 40 trillion of that has been allocated for direct spending. Due to negative bond yields, the Japanese government earns more interest than it pays on its debt. It should be running much more expansionary fiscal policy. China: Policy Normalization, Not Deleveraging Chart 9China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China’s combined credit/fiscal impulse peaked late last year (Chart 9). The impulse leads growth by about six months, implying that the tailwind from easier monetary and fiscal policies will fade over the rest of the year. Nevertheless, we doubt that China’s economy will experience much of a slowdown. First and foremost, the shock from the pandemic should fade, helping to revive consumer and business confidence. Second, the Chinese authorities are likely to pursue policy normalization, rather than outright deleveraging. Jing Sima, BCA’s chief China strategist, expects the general government deficit to remain broadly stable at 8% of GDP this year. She also thinks that the rate of credit expansion will fall by only 2-to-3 percentage points in 2021, bringing credit growth back in line with projected nominal GDP growth of 8%. Total credit was 290% of GDP at end-2020. Thus, credit growth of 8% would still generate 290%*8%=23% of GDP of net credit formation, providing more than enough support to the economy. II. Feature: Will The US Economy Overheat? As of February, US households were sitting on around $1.7 trillion in excess savings. About two-thirds of those savings can be chalked up to reduced spending during the pandemic, with the remaining one-third arising from increased transfer payments (Chart 10). The recently passed stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. This cash hoard will support spending. Already, real-time measures of economic activity have hooked up. Traffic congestion in many US cities is approaching pre-pandemic levels. OpenTable’s measure of restaurant occupancy is progressing back to where it was before the pandemic (Chart 11). J.P. Morgan reported that spending using its credit cards rose 23% year-over-year in the 9-day period through to March 19 as stimulus payments reached bank accounts. Anecdotally, airlines and cruise line companies have been expressing optimism on the back of a surge in bookings. Chart 10Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Chart 11Real-Time Measures Of Economic Activity Have Hooked Up Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   Meanwhile, the supply side of the economy could face temporary constraints. Under the stimulus bill, close to half of jobless workers will receive more income through to September from extended unemployment benefits than they did from working. This could curtail labor supply at a time when firms are trying to step up the pace of hiring. The Fed Versus The Markets In the latest Summary of Economic Projections released last week, the median “dot” for the fed funds rate remained stuck at zero through to end-2023. The bond market, in contrast, expects the Fed to start raising rates next year. Why is there a gap between the Fed and market expectations? Part of the answer is that the “dots” and market expectations measure different things. Whereas the dots reflect a modal, or “most likely” estimate of where short-term rates will be over the next few years, market expectations reflect a probability-weighted average. The fact that rates cannot fall deeply into negative territory – but can potentially rise a lot in a high-inflation scenario – has skewed market rate expectations to the upside. That said, there is another, more fundamental, reason at work: The Fed simply does not think that a negative output gap will lead to materially higher inflation. The “dots” assume that core PCE inflation will barely rise above 2% over the next two years, even though, by the Fed’s own admission, the unemployment rate will fall firmly below NAIRU in 2023 (Chart 12). Chart 12The Fed Sees Faster Recovery, Same Rate Path Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 13Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Is the Federal Reserve’s relaxed view towards inflation risk justified? The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s deflationary shock, lingering supply chain disruptions, the rebound in gasoline prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory (Chart 13). The Fed believes that PCE inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as supply disruptions dissipate and most fiscal stimulus measures roll off. Our bet is that the Fed will be right about inflation in the near term, but wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation is poised to rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and market participants. War-Time Inflation, But Which War? In some respects, the Fed sees the current environment as resembling a war, except this time the battle is against an invisible enemy: Covid-19. Chart 14 shows what happened to US inflation during WWI, WWII, the Korean War, and the Vietnam War. In the first three of those four wars, inflation rose but then fell back down after the war had concluded. That is what the Fed is counting on. What about the possibility that the coming years could resemble the period around the Vietnam War, where inflation continued to rise even though the number of US military personnel engaged in the conflict peaked in 1968?   Chart 14Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Chart 15Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In the near term, this does not appear to be a major risk. In 1966, when the war effort was ramping up, the US unemployment rate was two percentage points below NAIRU (Chart 15). As of February, US employment was still more than 5% below pre-pandemic levels.   Chart 16Employment Has Been Weak And Edging Lower At The Bottom Quartile Of The Wage Distribution Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We estimate that the US output gap currently stands at around 5%-to-6% of GDP. Among the bottom quartile of the wage distribution, employment is 20% below pre-pandemic levels, and has been edging lower, not higher, since last October (Chart 16). Thus, for now, hyperbolic talk of how fiscal stimulus is crowding out private-sector spending is unwarranted. Inflation Nation Looking further out, the parallels between today and the late sixties are more striking. As we discussed in a report titled 1970s-Style Inflation: Yes, It Could Happen Again, much of what investors believe about how inflation emerged during the late 1960s is either based on myths, or at best, half-truths. To the extent that there are differences between today and that era, they don’t necessarily point to lower inflation in the coming years. For example, in the late sixties, the baby boomers were entering the labour force, supplying the economy with a steady stream of new workers. This helped to temper wage pressures. Today, baby boomers are leaving the labour force. They accumulated a lot of wealth over the past 50 years – so much so that they now control more than half of all US wealth (Chart 17). Over the coming two decades, they will run down that wealth, implying that household savings rates could drop. By definition, a lower savings rate implies more spending in relation to output, which is inflationary. Chart 17Baby Boomers Have Accumulated A Lot Of Wealth Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? III. Financial Markets A. Portfolio Strategy Overweight Stocks Versus Bonds Stocks usually outperform bonds when economic growth is strong and money is cheap (Chart 18). The end of the pandemic and ongoing fiscal stimulus should support growth over the next 12-to-18 months, allowing the bull market in equities to continue. With inflation slow to rise, monetary policy will remain accommodative over this period. Chart 18AStocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Chart 18B... And Money Is Cheap ... And Money Is Cheap ... And Money Is Cheap The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, our research has shown that as long as bond yields do not rise enough to trigger a recession, stocks will shrug off the effect of higher yields (Chart 19 and Table 1). Indeed, there is a self-limiting aspect to how high bond yields can rise, and stocks can fall, in a setting where inflation remains subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today. Chart 19What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   It’s Not 2000 In recent months, many analysts have drawn comparisons between the year 2000 and the present day. While there are plenty of similarities, ranging from euphoric retail participation to the proliferation of dubious SPACs and IPOs, there is one critical difference: The forward earnings yield today is above the real bond yield, whereas in 2000 the earnings yield was below the bond yield (Chart 20). The US yield curve inverted in February 2000, with the 10-year Treasury yield peaking a month earlier at 6.79%. An inverted yield curve is one of the most reliable recession predictors. We are a far cry from such a predicament today. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 20% in real terms for equities to underperform bonds. Many other stock markets would have to decline by an even greater magnitude (Chart 21). Chart 20Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Chart 21Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds   Protecting Against Long-Term Inflation Risk The bull market in stocks will end when central banks begin to fret over rising inflation. In the past, central banks have used forecasts of inflation to decide when to raise rates. The Federal Reserve’s revised monetary policy framework, which focuses on actual rather than forecasted inflation, almost guarantees that inflation will overshoot the Fed’s target. This is because monetary policy fully affects the economy with a lag of 12-to-18 months. By the time the Fed decides to clamp down on inflation, it will have already gotten too high. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios, favor inflation-protected securities over nominal bonds, and own more “real assets” such as property. In fact, one of the best inflation hedges is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades, you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms. Gold Versus Cryptos Historically, gold has offered protection against inflation. Increasingly, many investors have come to believe that cryptocurrencies are a better choice. We disagree. As we recently discussed in a report titled Bitcoin: A Solution In Search Of A Problem, not only are cryptocurrencies such as Bitcoin highly inefficient mediums of exchange, they are also likely to turn out to be poor stores of value. Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 22). About 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. Much of the rest of the mining takes place in countries such as Russia and Belarus with dubious governance records. Bitcoin and ESG are heading for a clash. We suspect ESG will win out. Chart 22Bitcoin Is Not Your Eco-Currency Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? B. Equities Favor Cyclicals, Value, And Non-US Stocks Chart 23Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing The vast majority of stock market capitalization today is concentrated in large multinational companies that are more leveraged to global growth rather than to the growth rate of countries in which they happen to be domiciled. Thus, while country-specific factors are not irrelevant, regional equity allocation often boils down to figuring out which stock markets will gain or lose from various global trends. The end of the pandemic will prop up global growth. In general, cyclical sectors outperform when global growth is on the upswing (Chart 23). As Table 2 illustrates, stock markets outside the US have more exposure to classically cyclical sectors such as industrials, energy, materials, and consumer discretionary that usually shine coming out of a downturn. This leads us to favor Europe, Japan, and emerging markets. We place banks in the cyclical category because faster economic growth tends to reduce bad loans, while also placing upward pressure on bond yields. Chart 24 shows that there is a very close correlation between the relative performance of bank shares and long-term bond yields. As government yields trend higher, banks will benefit. Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 24Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Banks and most other cyclical sectors dominate value indices (Table 3). Not only is value still exceptionally cheap in relation to growth, but traditional value sectors have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 25). The likelihood that global bond yields put in a secular bottom last year, coupled with the emergence of a new bull market in commodities, makes us think that the nascent outperformance of value stocks has years to run.   Table 3Breaking Down Growth And Value By Sector Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 25AValue Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Chart 25BValue Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) US Corporate Tax Hikes Coming Finally, there is one country-specific factor worth mentioning, which reinforces our view of favoring non-US, cyclical, and value stocks: US corporate taxes are heading higher. BCA’s geopolitical strategists expect the Biden Administration and the Democrat-controlled Congress to raise the statutory corporate tax rate from 21% to as high as 28% later this year in order to fund, among other things, a major infrastructure investment program. Capital gains taxes will also rise. While tax hikes are unlikely to bring down the whole US stock market, they will detract from the relative performance of US stocks compared with their international peers. Cyclical sectors will benefit from the infrastructure spending. To the extent that such spending boosts growth and leads to a steeper yield curve, it should also benefit banks. In contrast, tech companies outside the clean energy sector will lag, especially if the bill introduces a minimum corporate tax on book income and raises taxes on overseas profits, as President Biden pledged to do during his campaign. C. Fixed Income Expect More US Curve Steepening As discussed above, inflation in the US and elsewhere will be slow to take off. However, when inflation does rise later this decade, it could do so significantly. Investors currently expect the Fed to start raising rates in December 2022, bringing the funds rate to 1.5% by the end of 2024 (Chart 26). In contrast, we think that a liftoff in the second half of 2023, preceded by a 6-to-12 month period of asset purchase tapering, is more likely. This implies a modest downside for short-dated US bond yields. Chart 26The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 Chart 27Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels In contrast, long-term yields will face upward pressure first from strong growth, and later from higher inflation. The 5-year/5-year forward TIPS yield currently stands at 0.35%, which is still below pre-pandemic levels (Chart 27). Given structurally looser fiscal policy, the 5-year/5-year forward TIPS yield should be at least 50 basis points higher, which would translate into a 10-year Treasury yield of a bit over 2%. Regional Bond Allocation While the Fed will be slow out of the gate to raise rates, most other central banks will be even slower. The sole exception among developed market central banks is the Norges bank, which has indicated its intention to hike rates in the second half of this year. Conceivably, Canada could start tightening monetary policy fairly soon, given strong jobs growth and a bubbly housing market. While the Bank of Canada is eager to begin tapering asset purchases later this year, our global fixed-income strategists suspect that the BoC will wait for the Fed to raise rates first. An early start to rate hikes by the Bank of Canada could significantly push up the value of the loonie, which is something the BoC wants to avoid. New Zealand will also hike rates shortly after the Fed, followed by Australia. Bank of England governor Andrew Bailey has downplayed the recent rise in gilt yields. Nevertheless, the desire to maintain currency competitiveness in the post-Brexit era will prevent the BoE from hiking rates until 2024. Among the major central banks, the ECB and the BoJ will be the last major central banks to raise rates. Putting it all together, our fixed-income strategists advocate maintaining a below-benchmark stance on overall duration. Comparing the likely path for rate hikes with market pricing region by region, they recommend overweighting the Euro area and Japan, assigning a neutral allocation to the UK, Canada, Australia, and New Zealand, and an underweight on the US. Credit: Stick With US High Yield Corporates Corporate spreads have narrowed substantially since last March. Nevertheless, in an environment of strong economic growth, it still makes sense to favor riskier corporate credit over safe government bonds. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over Euro area bonds. The former trade with a higher yield and spread than the latter (Chart 28). CHART 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Chart 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit-sensitive asset starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the middle of the distribution. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the Euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 29). Chart 29US High-Yield Stands Out The Most Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? D. Currencies Faster US Growth Should Support The Dollar In The Near Term… Chart 30US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The US has a “low beta” economy. Compared to most other economies, the US has a bigger service sector and a smaller manufacturing base (Chart 30). The US economy is also highly diversified on both a regional and sectoral level. This tends to make US growth less volatile than growth abroad. The relatively low cyclicality of the US economy has important implications for the US dollar. While the US benefits from stronger global growth, the rest of the world usually benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, dragging down the value of the dollar. This relationship broke down this year. Rather than lagging other economies, the US economy has led the charge thanks to bountiful fiscal stimulus and a successful vaccination campaign. As growth estimates for the US have been marked up, the dollar has caught a temporary bid (Chart 31). Chart 31US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar … But Underlying Fundamentals Are Dollar Bearish As discussed earlier in the report, growth momentum should swing back towards the rest of the world later this year. This should weigh on the dollar in the second half of the year. To make matters worse for the greenback, the US trade deficit has ballooned in recent quarters. The current account deficit, a broad measure of net foreign income flows, rose by nearly 35% to $647 billion in 2020. At 3.1% of GDP, it was the largest shortfall in 12 years (Chart 32). Consistent with the weak balance of payments picture, the dollar remains overvalued by about 10% on a purchasing power parity basis (Chart 33). Chart 32The Widening US External Gap The Widening US External Gap The Widening US External Gap Chart 33The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value Historically, the dollar has weakened whenever fiscal policy has been eased in excess of what is needed to close the output gap (Chart 34). Foreigners have been net sellers of Treasurys this year. It is equity inflows that have supported the dollar (Chart 35). However, if non-US stock markets begin to outperform, foreign flows into US stocks could reverse. Chart 34The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs Chart 35Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Chart 35Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Meanwhile, stronger US growth has pushed long-term real interest rate differentials only modestly in favor of the US. At the short end of the curve, real rate differentials have actually widened against the US since the start of the year, reflecting rising US inflation expectations and the Fed’s determination to keep rates near zero for an extended period of time (Chart 36). Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) On balance, while the dollar could strengthen a bit more over the next month or so, the greenback will weaken over a 12-month horizon. Chester Ntonifor, BCA’s chief currency strategist, expects the dollar to fall the most against the Norwegian krone, Swedish krona, Australian dollar, and British pound over a 12-month horizon. In the EM space, stronger global growth will disproportionately benefit the Mexican peso, Chilean peso, Colombian peso, South African rand, Czech koruna, Indonesian rupiah, Korean won, and Singapore dollar. Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Consistent with our equity views, a weaker dollar would be good news for cyclical equity sectors, non-US stock markets, and value stocks (Chart 37). E. Commodities Favorable Outlook For Commodities Strong global growth against a backdrop of tight supply should sustain momentum in the commodity complex over the next 12-to-18 months. Capital investment in the oil and gas sector has fallen by more than 50% since 2014 (Chart 38). BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects annual growth in crude oil demand to outstrip supply over the remainder of this year (Chart 39). Chart 38Oil & Gas Capex Collapses In COVID-19’s Wake Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 39Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Chart 40). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of annual copper production. Chart 40ACopper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Chart 40B...As Will Aluminum ...As Will Aluminum ...As Will Aluminum China’s Commodity Demand Will Remain Strong Chart 41China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 41). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Global Investment Strategy View Matrix Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Special Trade Recommendations Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Current MacroQuant Model Scores Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?

Highlights Duration & The Fed: Unlike the bond market, the Fed is being intentionally cautious about how quickly it revises its interest rate expectations higher, focusing more on hard economic data than on surveys. We expect the Fed dots to move up later this year as the hard economic data improve, validating current pricing in the bond market. Maintain below-benchmark portfolio duration. Yield Curve: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up. Feature The pain in the bond market continues. The 10-year Treasury yield rose again last week, closing at 1.74% on Friday, and the Bloomberg Barclays Treasury Index has now returned -6.1% since it peaked last August. If we use the peak-to-trough drawdown in the Treasury Index as our gauge, we are now in the midst of one of the five worst bond selloffs of the past 50 years. During that 50-year period, the current bearish bond move is only surpassed by the 2009, 2003, 1994 and 1980 episodes (Chart 1). Chart 1A Historic Bond Rout A Historic Bond Rout A Historic Bond Rout That said, the current bond selloff might still have a lot of runway. In level terms, the 30-year Treasury yield has only just recaptured its 2020 peak and the 10-year yield hasn’t even done that (Chart 2). Then, there’s another 101 bps of upside in the 30-year yield and 150 bps of upside in the 10-year yield just to get back to their 2018 peaks, yield levels that aren’t exactly distant memories. Yields do look stretched if we look at long-dated forwards. The 5-year/5-year forward Treasury yield, for example, is already well above its 2020 peak. The large increase in the 5-year/5-year forward yield is the result of Fed policy keeping the short-end of the yield curve capped (Chart 2, bottom 2 panels) forcing the bulk of Treasury weakness to be felt at the long-end. The 5-year/5-year forward Treasury yield is important because it reflects the market’s expectation of where the fed funds rate will settle in the long-run. In fact, you can use survey estimates of the long-run neutral fed funds rate to get a useful fair value range for the 5-year/5-year forward. At present, the 5-year/5-year forward yield has pushed well above this survey-derived fair value range (Chart 3), though it’s important to note that it is still 75 bps below its 2018 peak. Survey estimates of the long-run neutral fed funds rate were revised down as growth disappointed in 2019, it stands to reason that they could be revised higher as growth improves this year, thus moving the fair value range up as well. Chart 2Yields Can Rise Further Yields Can Rise Further Yields Can Rise Further Chart 35-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated In fact, whether that process of upward revisions to survey estimates of the long-run neutral fed funds rate begins is an important near-term question for the bond market. Upward revisions would signal further upside in long-dated yields and more curve steepening ahead. Static long-run neutral rate estimates would signal that the upside in long-maturity yields is limited. In that latter case, the cyclical bond bear market would transition to a less severe bear-flattening phase where short-maturity yields eventually catch up to the long-end as the Fed tightens policy. It’s currently unclear how those survey estimates will evolve – we will get March updates for both surveys shown in Chart 3 on April 8th – but for now it’s too soon to say that the 5-year/5-year forward yield has peaked. We continue to recommend maintaining below-benchmark portfolio duration as we keep tabs on our Checklist To Increase Portfolio Duration.1 Currently, our Checklist is not screaming out for us to make a change. Explaining The Disagreement Between The Fed And The Market We expected that Fed policymakers would revise up their interest rate forecasts at last week’s FOMC meeting, but we also expected that the forecasts wouldn’t rise far enough to match the rate hike path that is currently priced in the market.2 This is in fact what happened, though the Fed was slightly more dovish than we anticipated. Only 7 out of 18 FOMC participants expect any rate hikes at all before the end of 2023, while the overnight index swap curve is discounting more than four 25 basis point hikes by then (Chart 4). Chart 4Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed What explains this divergence between the market and the Fed? Perhaps bond investors are simply ignoring the Fed’s dovish message. In that case, we should expect yields to fall as it becomes clear that the Fed intends to keep rates pinned at zero for much longer than is currently priced in the curve. Or perhaps Fed policymakers just don’t appreciate the surge in economic activity that is about to unfold. In that case, their interest rate forecasts (the “dots”) will rise sharply in the coming months as the economic data improve. Chair Powell gave a hint about how we should think about the divergence between the market and the “dots” in his post-meeting press conference. He said that the Fed wants to see “actual progress” towards its economic objectives not “forecast[ed] progress”, and he noted that this increased focus on “actual progress” is “a difference from our past approach.”3 In other words, the Fed is making a concerted effort to take a more backward-looking approach to policymaking under its new Average Inflation Targeting regime. It doesn’t want to tighten policy in response to a forecast of stronger growth in the future only to get whipsawed if that forecast doesn’t pan out. It would rather err on the side of tightening too late and then possibly have to move more quickly if it falls behind the curve. The market, by contrast, is a purely forward-looking discounting mechanism. Market prices move quickly to incorporate new information but are often caught offside. We are reminded of Paul Samuelson’s famous quip that the stock market has predicted nine of the past five recessions. This explains exactly what is happening right now. The market is looking ahead, taking its cues from survey data (or “soft data”) such as the ISM indexes that are pointing toward a sharp rise in economic activity and inflation. The Fed, by contrast, is endeavoring to focus more on the actual hard economic data such as the unemployment rate, industrial production and consumer price indexes. These hard economic data simply haven’t improved that much yet. The last section of this report (titled “Economy: Hard Vs Soft Data”) gives some examples of how the hard and soft economic data have diverged. Chart 5The Path Back To Maximum Employment The Path Back To Maximum Employment The Path Back To Maximum Employment Ultimately, the disagreement between the market’s funds rate expectations and the Fed’s dots will be resolved as the hard economic data are released during the next few months. Those data will either validate the current message from economic surveys, causing the Fed to revise up its rate forecasts, or disappoint market expectations, causing market forecasts and bond yields to fall. In this regard, the hard economic data on the labor market will be particularly important. The Fed has said that it will not lift rates until “maximum employment” is achieved. In practice, “maximum employment” means that the unemployment rate will fall into a range of 3.5% - 4.5%, consistent with the Fed’s estimates of the natural rate, and the labor force participation rate will recover to pre-COVID levels (Chart 5). The top row of Table 1 shows that average monthly employment growth of 419k is required to achieve that target by the end of 2022. We have made the case in prior reports that, though that number seems high, it is achievable.4   Table 1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date The Fed Looks Backward While Markets Look Forward The Fed Looks Backward While Markets Look Forward It’s also worth noting that the Fed’s median unemployment rate forecast was revised significantly lower last week. The Fed is now looking for an unemployment rate of 4.5% by the end of this year and 3.9% by the end of 2022 (Chart 5, top panel). The fact that the Fed doesn’t project any rate hikes during this timeframe can only mean that policymakers aren’t forecasting a similar recovery in the labor force participation rate. The bottom line is that, unlike the market, the Fed is being intentionally cautious about how quickly it revises its funds rate expectations higher, focusing more on hard economic data than surveys. Eventually, the disagreement between the hard and soft economic data will be resolved and either the Fed dots will move toward the market, or the market will move toward the Fed. Our sense is that the Fed is probably being overly cautious and that their forecasts will eventually move toward the market, validating current bond yields. Too Early To Expect Curve Flattening We have been recommending nominal Treasury curve steepeners for some time, on the view that the yield curve will trade directionally with yields. This means that rising yields will coincide with curve steepening.5 This correlation has held up extremely well, but we know that it won’t last forever. Eventually, we will be close enough to Fed rate hikes that the yield curve will start to flatten as yields rise. This process will begin at the long-end of the curve and gradually shift toward the short-end as Fed liftoff approaches. Chart 6 shows how the correlation between the level of Treasury yields and different yield curve slopes has held up during the recent surge in bond yields. For the most part, the tight correlation between rising yields and steeper curves remains intact, with the 10/30 slope being the exception (Chart 6, bottom panel). It looks like during the past month the 10/30 slope has transitioned from a bear-steepening/bull-flattening regime into a bear-flattening/bull-steepening regime. The investment implication is that the short position of a curve steepener trade should be applied to the 10-year note not the 30-year bond, particularly for duration-neutral steepeners. It’s difficult to know exactly when the other segments of the yield curve will transition from their bear-steepening/bull-flattening regimes into bear-flattening/bull-steepening regimes, but we suspect that the current correlations have quite a bit more running room. If we look at what occurred prior to the last time that the Fed lifted rates off the zero bound, in December 2015, we see that most curve segments didn’t start to bear-flatten until a few months before liftoff (Chart 7) Chart 6Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Chart 7Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff In terms of how to implement a yield curve steepener, we have been recommending a position long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. We are sticking with that position for now, as it has performed well even as the 2/5/10 butterfly spread has widened in recent weeks (Chart 8). We expect it will continue to perform well as long as both the 2/5 and 5/10 yield curve slopes continue to steepen. Once we suspect that the 5/10 slope is transitioning into a bear-flattening/bull-steepening regime, we will have to either shift into a curve flattener or a curve steepener that is focused more at the short-end of the curve. Chart 85/10 Slope Still Steepening 5/10 Slope Still Steepening 5/10 Slope Still Steepening Bottom Line: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: Hard Vs. Soft Data Chart 9IP Lags The PMI IP Lags The PMI IP Lags The PMI Chart 10Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead As noted above, the US economy is at an interesting inflection point where, owing to large-scale fiscal stimulus and an effective COVID vaccination rollout, there is a lot of optimism about the future. This optimism is showing up in how people respond to surveys about their economic and business expectations, but it has not yet translated into better actual economic outcomes. The ISM Manufacturing PMI survey is a case in point. It surged to 60.8 in February, its highest level since 2018, but actual measured industrial production continues to contract in year-over-year terms (Chart 9). In all likelihood, this is simply a result of surveys (“soft data”) leading the hard data. A simple linear regression fit between industrial production and the PMI shows that wide negative divergences have a habit of showing up during recessions, only for the gaps to close very quickly in the early stages of the recovery. We see the same dynamic at play in the inflation data. Actual core CPI inflation has not moved up significantly, but surveys indicate that price pressures are rising fast (Chart 10). Bottom Line: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on our Checklist please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210317.pdf 4 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Recent Changes Lock in gains of 4.3% and downgrade the S&P construction machinery & heavy trucks index to neutral, today. Table 1 Pricing Power Update Pricing Power Update ​​​​​​​ Feature While the Fed’s dots dovishly surprised market participants last week, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s 2021 core PCE price inflation estimate to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. Clearly, the Fed is in a bind as it tries to strike a delicate balance between short and long term rates. Our thesis, first posited on February 1, remains that the bond market will keep on testing the Fed’s resolve until the FOMC members start to “talk about talking about tapering”. An economy running on steroids buoyed both by ultra loose monetary and fiscal policies at a time when it is primed to reopen at full speed around Memorial Day is inherently inflationary. Under such a backdrop, the subsurface equity market’s response makes perfect sense. “Back-To-Work” stocks left “COVID-19 Winners” in the dust, small caps outperformed the Nasdaq 100, the Value Line Arithmetic Index and the RVRS1 exchange traded fund outshone the SPX and the S&P 495 trounced the S&P 5 (Chart 1). In other words, when growth is scarce as during last year’s recession investors flock to growth stocks, now that growth is abundant investors are cornering value stocks with the highest degree of operating leverage (top panel, Chart 1). While this deck reshuffling may go on temporary hiatus as the 10-year US Treasury yield pauses for breath, this sector rotation has cyclical staying power. Given this looming inflationary impulse context, today we update our Corporate Pricing Power Indicator (CPPI). Chart 2 shows that our CPPI has swung over 10 percentage points from the recent trough, accelerating north of 5%/annum pace. In fact, our diffusion index of the 60 selling price categories we track has vaulted to all-time highs (second panel, Chart 2). Chart 1Anatomy Of The Market Anatomy Of The Market Anatomy Of The Market Chart 2Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Wage inflation is also coming out of hibernation, with job switchers outpacing job stayers’ salary inflation, according to the latest Atlanta Fed wage growth trackers (third panel, Chart 2). Importantly, the most recent NFIB survey showed that small businesses have the hardest time filling job openings by finding qualified labor. Over the past three decades, this backdrop has been conducive to wage inflation (Chart 3), and if history at least rhymes, a pick-up in wage inflation is in the cards in the back half of the year (Chart 4). Our sense is that the economic reopening will by then be at full speed, further exacerbating wage pressures. Chart 3Inflation… Inflation… Inflation… While profit margins are on the cusp of shaking off the remnants of the COVID-19 accelerated recession, sell-side analysts’ 12-month forward profit margin estimates show no signs of input cost pressures, at least not yet. The risk is that corporations may find it challenging to pass on these looming wage increases down the supply chain and all the way to the consumer in order to preserve margins (bottom panel, Chart 2). The jury is still out on who will eventually have to bear the brunt of inflationary pressures, especially in the context of rising fiscal deficits (i.e. personal current transfers). Drilling beneath the surface, our CPPI signals that genuine inflationary pressures are mounting as supply chains are strained causing shortages on a slew of manufacturing industries. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 4…Is Coming …Is Coming …Is Coming Table 2Industry Group Pricing Power Pricing Power Update Pricing Power Update While 68% of the industries we cover are outright lifting selling prices, half are doing so at a faster clip than overall inflation. With regard to pricing power trends, encouragingly only 30% of the industries we cover are in a downtrend (Table 2). Services industries mostly populate the bottom half of Table 2 with the usual suspects – airlines, air freight, hotels and movies & entertainment – that COVID-19 wreaked the most havoc to occupying the bottom four spots. Nevertheless, this is looking in the rearview mirror. The tide is slowly turning as a recent update from the TSA highlighted that passenger enplanements are perking up. Lumber has reached escape velocity and has sustained forest products atop our table with a meteoric year-over-year growth rate of 149%! Commodities populate nine out of the top ten spots and while gold has fallen down the ranks since our last update, it is still expanding at a near 10%/annum rate, despite the greenback’s year-to-date rise. Energy related commodities are on fire and peak oil inflation will hit in April/May due to base effects. Keep in mind that last spring WTI crude oil prices sank into a deeply negative print per bbl. While at first sight all seems upbeat in the commodity complex, beneath the surface some cracks are forming. This week, we revisit our number one macro risk for the back half of the year: China’s pending slowdown, and downgrade a deep cyclical capital goods sub-group to neutral. Gauging China’s Slowdown Cresting in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel, Chart 5), and now we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel, Chart 5), and the near-term risk is that the S&P 500 may be next in line (top panel, Chart 5), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Taking cue from Chinese financial market data is also instructive. The MSCI China stock price index, its short-term momentum, net EPS revisions and 12-month forward EPS growth all troughed last spring. It is slightly unnerving that by all these metrics China’s stock market recovery is coming off the boil and may be a precursor to a soft-patch in the coming months (Chart 6). Chart 5Monitor China Closely Monitor China Closely Monitor China Closely Chart 6What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? Importantly, select commodities, especially ones that are hypersensitive to Chinese activity, appear exhausted and have likely hit, at least a temporary, zenith. While anecdotes of metal related scams and thefts are mushrooming especially catalytic converters mostly owing to rare earths soaring prices, we would not be surprised were bronze/copper statues to start disappearing and sold for scrap, as was prevalent in the mid-2000s commodity super cycle. Dr. Copper has more than doubled in the past year, is near all-time highs and already discounts a lot of good China recovery news (top panel, Chart 7). Historically, Google Trends searches for “commodity super cycle” have been closely correlated with cyclicals/defensives relative performance and the recent spike near all-time highs likely corroborates that the Chinese recovery is well advanced (Chart 8). Chart 7Glass Ceiling Glass Ceiling Glass Ceiling Chart 8“Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? WTI crude oil prices have also jumped over $100/bbl after hitting the negative $37/bbl mark last April. In the mid-60s/bbl crude oil has likely hit a ceiling and will have a tough time surging past this long term resistance. Sentiment is as extreme as it was during the Desert Storm in the early 1990s, which is the last time the oil RSI jumped over 80 (Chart 9)! Chart 9Slippery Slope? Slippery Slope? Slippery Slope? The Australian dollar, a commodity currency levered to China’s wellbeing, has also been on a tear since last March with AUDUSD rising from 0.55 to roughly 0.80. The Aussie is currently at the upper band of its range, since the Hawke/Keating government floated it in 1983, and facing stiff resistance. There are rising odds that AUDUSD is also sniffing out some China softness in the coming months (bottom panel, Chart 7). Finally, Chinese surveys and money aggregates data also signal that a garden variety slowdown will take root, especially post the 100-year Communist Party anniversary this summer. The Chinese manufacturing PMI is awfully close to the 50 expansion/contraction line, at a time when both M1 money supply has ticked lower and the total social financing impulse has rolled over (Chart 10). Tack on our sister’s China Investment Strategy’s recent estimate of a further steep deceleration in the latter and factors are falling into place for an engineered slowdown in China in the back half of the year (bottom panel, Chart 10). Bottom Line: China is on the cusp of a slowdown, remains a key macro risk to monitor, and thus we use this opportunity to book gains in a deep cyclical industrials sub-group and downgrade to neutral. Chart 10Keep Your China Guard Up Keep Your China Guard Up Keep Your China Guard Up CAT Stalling? As China’s economic growth downshifts, we are compelled to book gains in machinery stocks and downgrade to neutral. This sub-surface industrials sector move comes on the heels of last week’s upgrade in the more domestically focused railroads, and does not affect the broad sector’s overweight stance. First, machinery stocks are extremely overbought by historical standards outpacing the SPX by 36% on a year-over-year basis. Valuations have also spiked: the relative price to sales ratio is back near par and trades at a 25% premium to the historical average (Chart 11). Such lopsided positioning is fraught with danger and could at least temporarily reverse in a violent fashion. Second, while the US dollar has been boosting the industry’s exports and adding to machinery P&L via positive translation gains, the greenback’s year-to-date appreciation will eat into profits, at the margin, in the back half of the year (second & middle panels, Chart 12). Chart 11Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 12First Signs Of Cracks Appearing First Signs Of Cracks Appearing First Signs Of Cracks Appearing Sell-side analysts have taken notice and net profit revisions have topped out. Similarly, our EPS growth macro models suggest that machinery stocks will struggle to outearn the SPX (Chart 12). Lastly, as China goes, so go machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (fourth panel, Chart 12). Tack on the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the outlook for machinery end-demand darkens further (Chart 13). Nevertheless, before getting outright bearish on machinery stocks, there are a few offsetting factors. Commodity prices, while toppy, remain firm, and alleviate fears of a severe Chinese slowdown. Moreover, Chinese excavator sales are on a tear surging to a three year high. While China’s manufacturing PMI has petered out, both the global PMI and developed market PMIs are reaccelerating. As the global economy reopens, services PMIs will further boost the global composite PMIs (second & bottom panels, Chart 14). Chart 13Chart Of The Year Candidate Chart Of The Year Candidate Chart Of The Year Candidate Finally, while our relative EPS growth models hover near the zero line, the same is also true for the sell side’s profit growth estimates and represent a modest hurdle for the industry to surpass (third panel, Chart 14). Netting it all out, China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Chart 14Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Bottom Line: Downgrade the S&P construction machinery & heavy trucks index to neutral today for a relative gain of 4.3% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     The Reverse Cap Weighted U.S. Large Cap ETF (Ticker: RVRS) provides exposure to the companies in the S&P 500 index. However, while traditional market cap weighted indexes such as the S&P 500 weight companies inside the index by their relative market capitalization, RVRS does the opposite, weighting companies by the inverse of their relative market cap. By investing smallest-to-biggest, the fund is tilting investment exposure to the smaller end of the market cap spectrum within the large cap space. https://exponentialetfs.com/wp-content/uploads/2021/01/Reverse-ETF-Factsheet_2020.12.311.pdf 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

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Thursday, March 25 at 10:00 am EDT and Friday March 26 at 9:00 am HKT. I look forward to your comments and questions during the webcast. Best regards, Chester Highlights During bear markets, counter-trend rallies in the dollar are capped around 4%. This time should be no different. Meanwhile, unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real short rates will drop. The relative equity performance of the US is critical for the dollar. Reserve diversification out of dollars has also started to place a natural ceiling against other developed market currencies. An attractive opportunity is emerging to short the AUD/CAD cross. Feature The 1.7% rise in the US dollar this year is reinvigorating the bull case. When presenting our key views last year, we highlighted that the DXY index was at risk of a 2-4% bounce.1 We reaffirmed this view in our January report: Sizing A Potential Dollar Bounce. At the time, the DXY index was at the 90 level, suggesting the rally should fizzle around 94. Therefore, the key question is whether the nascent rise in the DXY will punch through this level, or fade as we originally expected. The short-term case for the dollar remains bullish. The currency is much oversold. Meanwhile, real interest rates are moving in favor of the US, vis-à-vis a few countries. Third and interrelated, economic momentum in the US is quite strong, compared to other G10 countries. With the rising specter of a market correction, the dollar could also benefit from safe haven flows towards the US. The Federal Reserve’s meeting yesterday certainly reaffirmed that short-term rates will remain anchored near zero, at least until 2023. The Fed does not see inflation much above 2% a couple of years out. Nevertheless, a lot can change in the coming months. Cycles, Positioning And Interest Rates The dollar tends to move in long cycles, with the latest bull and bear markets lasting about a decade or so. In other words, the dollar is a momentum currency. As such, determining which regime you are in is critical to assessing the magnitude of any rally. This is certainly the case when sentiment remains overly dollar bearish, as now. During bear markets, counter-trend rallies in the dollar are capped around 4-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-1). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-1The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign Long interest rates have also been moving in favor of the dollar, especially relative to the euro area, Japan, and even Sweden. Currencies are driven by real interest rate differentials, and higher US yields are bullish. With the Fed giving no indication it will prevent the curve from steepening further, US interest rates could keep gaping higher. However, currencies are about relative rate differentials, and the rise in US interest rates has not been in isolation. Rates in the UK, Australia and New Zealand, countries that have managed the COVID-19 crisis pretty well, are beginning to rise faster than in the US (Chart I-2). Chart I-2A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields US Versus World Growth The rise in US interest rates has been justified by better economic performance. Whether looking at purchasing managers’ indices, economic surprise indices, or even GDP growth expectations, the US has had the upper hand (Chart I-3). The Fed expects US growth to hit 6.5% this year. This is well above what other central banks expect for their domestic economies. The ECB expects 4%, the BoJ expects 3.9%, and the BoC expects 4.6% (Table I-1). Chart I-3AThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Chart I-3BThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Table I-1The US Leads In Growth And Inflation This Year Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears However, economic dominance can be transient, especially in a world of flexible exchange rates.  For one, a higher dollar will sap US growth via the export channel. This is especially the case since the starting point is an expensive currency. On a real effective exchange rate basis, the dollar is above its long-term mean (Chart I-4). Meanwhile, we expect the rest of the world to perform better as economies reopen. The services PMI in the US is already close to a cyclical high, similar to Sweden (Chart I-5). These are among the countries with the least stringent COVID-19 measures in the western hemisphere. This suggests that other economies, even manufacturing-centric ones, could see a coiled-spring rebound in growth as we put this pandemic behind us. Chart I-4The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-5The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The sweet spot for most economies is when growth is rising but inflation is low, allowing the resident central bank to keep policy dovish. However, it is an open question if the US can continue to boost spending, without a commensurate rise in inflation. The OECD estimates that the US output gap will close by 2022, with the $1.9-trillion fiscal package. This will put the US well ahead of any G10 country (Chart I-6). Unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real rates will drop (Chart I-7). Rising nominal rates and falling real yields will be anathema to the dollar. Chart I-6The US Output Gap Will Soon Close The US Output Gap Will Soon Close The US Output Gap Will Soon Close Chart I-7Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Equity Rotation And The Dollar A currency manager once noted that the most important variable to pay attention to when making FX allocations is relative equity performance. This might seem bizarre at first blush, but stands at the center of what an exchange rate is – a mechanism that equalizes rates of return across countries. As such while bond flows are important for exchange rates, equity flows matter as well. The relative equity performance of the US is critical for two reasons. First, the US equity market tends to do relatively better during bear markets. This was the case last year and during the 2008 crisis. Second, the outperformance of the US over the last decade has dovetailed with a dollar bull market (Chart I-8). It is rare to find a currency that has performed well both during equity bull and bear markets. If past is prologue, the near-term risks for the dollar are to the upside, especially if the market rally encounters turbulence as yields rise. The put/call ratio in the US is at a 5-year nadir. A move towards parity could violently pull up the DXY index (Chart I-9). However, a garden-variety 5-10% correction in the SPX should correspond to a shallow bounce in the DXY. This will also fit the pattern of bear market USD rallies, as we already highlighted in Chart I-1. Chart I-8US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar Chart I-9The Dollar Could Rise In ##br##A Market Reset The Dollar Could Rise In A Market Reset The Dollar Could Rise In A Market Reset At the same time, any correction could usher in a violent rotation from cyclicals to defensives, especially if underpinned by higher interest rates. The performance of energy and financials are a leap ahead of other sectors in the S&P 500 this year. Importantly, they also massively outperformed during the February drawdown. Meanwhile, valuations are heavily elevated in the US compared to the rest of the world. This is true for growth sectors compared to value, and cyclicals compared to defensives. Throughout history, both exchange rates and valuations have tended to mean revert. Long-Term Dollar Outlook The 2020 pandemic was a one-in-a-hundred-year event. Coordinated fiscal and monetary stimuli have ushered in a new economic cycle. As a counter-cyclical currency, the dollar tends to do poorly (Chart I-10). This is because monetary stimulus provides more torque to economies levered to the global cycle. Once growth achieves escape velocity, the currencies of these more pro-cyclical economies benefit. The IMF projects that non-US growth should outpace US growth after 2021. Meanwhile, it is an open question that any rally in the dollar will be durable. The key driver behind the dollar increase in 2020 was a global shortage. Not only has the Fed extended its liquidity provisions to foreign central banks until September this year, the share of offshore US dollar debt issuance has fallen by a full 9 percentage points (Chart I-11). Simply put, the Fed is flooding the system with dollar liquidity at the same time that foreign entities are weaning themselves off it Chart I-10The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 Chart I-11Share Of US Dollar Debt ##br##Rolling Over Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears The reason behind this is balance-of-payment dynamics. The market has realized that ballooning twin deficits in the US come at a cost. For foreign issuers, it is the prospect of rolling over US-denominated debt at a much higher coupon rate. For bond investors, it is currency depreciation, especially if fiscal largesse becomes too “sticky,” and stokes inflation. As such, bond investors continue to avoid the US, despite rising rates (Chart I-12). Finally, reserve diversification out of dollars has started to place a natural ceiling on the US dollar, especially against other developed market currencies. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart I-13). This will place a durable floor under developed market currencies in general and gold in particular. The Chinese RMB has also been gaining traction in global FX reserves. Chart I-12Little Appetite For US ##br##Treasurys Little Appetite For US Treasurys Little Appetite For US Treasurys Chart I-13Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar More specifically, the role of the USD/CNY exchange rate as a key anchor for emerging market currencies will rise, especially if the RMB remains structurally strong.2 The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. Swap agreements entail no exchange of currency, but are about confidence. The PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves. The dollar will remain the global reserve currency for years to come. However, a slow pivot towards reserve diversification will act as a structural headwind for the dollar. Housekeeping Chart I-14AUD/CAD Is Correlated To The VIX Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears We were stopped out of our CAD/NOK trade for a profit of 3.1%. The resilience of the US economy is benefiting the CAD more than the NOK for now. However, the Norges Bank confirmed it might be one of the first central banks to lift rates, as early as this year. We are both short USD/NOK and EUR/NOK and recommend sticking with these positions. Second, the growing spat between the EU and the UK could lead to more volatility in our short EUR/GBP position. Our target remains 0.8, but we are tightening stops to 0.865 to protect profits. The BoE left interest rates unchanged, but struck a constructive tone. This will bode well for cable, beyond near-term volatility. Third, our short USD/JPY position was stopped out amid the dollar rally. We are standing aside for now, but will reopen this trade later. Finally, a rise in volatility will boost the dollar, but also benefit short AUD/CAD positions. We are already short the AUD/MXN, but short AUD/CAD could be more profitable should market turmoil persist (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see the Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020. 2 Please see Foreign Exchange Strategy Currency In-Depth Report, titled “Will The RMB Continue To Appreciate?,” dated February 26, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Most data out of the US has been robust: Both PPI, import and export prices were in line with expectations for February. The PPI ex food and energy came in at 2.5% year-on-year. Empire manufacturing was robust at 17.4 in March, versus 12.1 last month. Housing starts and building permits came in a nudge below expectations in February, at 1421K and 1682K. The one disappointment was retail sales, which fell 3.3% year-on-year in February. The DXY index rose slightly this week. The FOMC remained dovish, without any revision to its median path of interest rate hikes. The markets disliked its reticence on rising long-bond yields. As such, equities are rolling over as yields continue to creep higher. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area are mending: The ZEW expectations survey rose to 74 in March, from 69.6. For Germany, the improvement was better at 76.6 from 71.2. The trade balance remained at a healthy €24.2bn euro surplus in January. The euro fell by 0.6% amidst broad dollar strength. With the ECB committed to cap the rise in yields and rise in peripheral spreads, relative interest rates will move against the euro. Sentiment remains elevated, and so a healthy reset is necessary to wash out stale longs. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been mixed: Core machinery orders grew 1.5% year-on-year in January. Exports fell by 4.5% in January, while imports rose by 11.8%. This has shifted the adjusted trade balance to a deficit of ¥38.7bn yen. The Japanese yen fell by 0.4% against the US dollar this week, and remains the weakest G10 currency this year. Rising yields have seen Japanese investors stampede into overseas markets such as the UK, while pushing down the yen. We remain yen bulls, but will stand aside for now since it could still go lower in the short term. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been weak: Industrial production and construction output fell by 4.9% and 3% year-on-year in January. Monthly GDP growth fell by 2.9% in January. Rightmove house prices rose 2.7% year-on-year in March. The pound fell by 0.4% against the dollar this week. It however remains the best performing currency this year. The BoE kept monetary policy on hold, but struck a hawkish tone as vaccination progresses, giving way to higher mobility in the summer. We remain long sterling via the euro. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home prices rose by 3.6% in the fourth quarter. Modest home appreciation is welcome news by the RBA, given high-flying prices in its antipodean neighbor. The employment report was solid. There were 88.7K new jobs in February, all full-time. This pushed down the unemployment rate to 5.8% from 6.4%. The Aussie fell by 0.4% this week. The Australian recovery is fast approaching escape velocity, forcing the RBA to contain a more pronounced rise in long-bond yields. We remain long AUD/NZD. In the very near term, a market shakeout could pull the Aussie lower, favoring short AUD/CAD positions.  Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data out of New Zealand was weak: Credit card spending fell by 10.6% year-on-year in January. Q4 GDP contracted by 1% both year-on-year and quarter-on-quarter. The current account remains in deficit at NZ$-2.7bn for Q4. The New Zealand dollar fell by 0.9% against the US dollar this week. The new rule to include house prices in setting monetary policy will be a logistical nightmare for the RBNZ. In trying to achieve financial stability, the RBNZ will have to forego some economic stability, especially if the country still requires accommodative settings. Confused messaging could also introduce currency volatility. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 There was a data dump in Canada this week: The economy added 259.2K jobs in February. This pushed down the unemployment rate from 9.4% to 8.2%. Wages also increased by 4.3% in February. The Nanos confidence index rose from 60.5 to 62.7 in the week of March 12. Housing starts rose by 246K in February, as expected. The BoC’s preferred measures of CPI came in close to the 2% target. Headline CPI was weaker at 1.1% in February. The Canadian dollar rose by 0.3% against the US dollar this week. The correction in oil prices could set the tone for the near-term performance of the loonie, despite robust domestic conditions. However, at the crosses, CAD should have upside. We took profits on our short CAD/NOK position this week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Producer and import prices fell by 1.1% year-on-year in February. February CPI releases also suggest the economy remains in deflation. The Swiss franc fell by 0.4% against the US dollar this week. Safe-haven currencies continue to be sold as yields rise, making the Swiss franc the worst performing currency this year after the yen. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors to stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The trade balance remained in surplus of NOK 25.1bn in February. The Norges bank kept interest rates on hold at 0%. The NOK fell by 1.2% against the dollar this week. The trigger was the selloff in oil prices. However, with the Norges bank signaling a rate hike later this year, placing it ahead of its G10 peers, there is little scope for the NOK to fall durably. Inflation in Norway is above target, and higher mobility later this year will benefit oil-rich Norway. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data releases were a slight miss: Headline CPI came in at 1.4% in February. Core CPI came in at 1.2%. The unemployment rate remained at 8.9% in February. The Swedish krona fell by 0.8% against US dollar this week. Sweden is struggling to contain another wave of the pandemic and this has weighed on the currency this year. The saving grace for the economy has been a global manufacturing cycle that continues humming. Until Sweden is able to get past the pandemic, the currency will continue trading in a stop-and-go pattern. We remain long the SEK on cheap valuations and as a play on the global industrial cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Stimulus checks will not be inflationary. Most households will regard them as additional wealth, and the propensity to spend additional wealth is very low. The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, whereas actual prospective inflation is negatively correlated with commodity prices. When, as now, the crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). The real bond yield is much higher than the bond market is pricing, which means that equities and other risk-assets are more expensive than they appear. Fractal trades shortlist: stocks versus bonds, 30-year T-bond, NOK/PLN. Feature Chart of the WeekCrude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Major anomalies should not exist in the financial markets, and least of all in the government bond market which is supposed to be the most efficient market of all. But a major anomaly does exist. The anomaly is in the way that the bond market prices inflation. More about that in a moment, but let’s first discuss whether the current surge in inflation expectations is warranted. The Inflationary Impact Of Stimulus Checks Is Exaggerated Inflation expectations have risen. And they have risen especially in the US, for two reasons. First, compared with Europe, the US vaccination roll-out appears to be going relatively smoothly. Second, the US government has been more pro-active in stimulating the economy, especially in the form of issuing stimulus checks to households, as well as other so-called ‘personal current transfer payments.’ Given that this has boosted incomes while spending has been constrained, the US household sector has amassed a war chest of savings. The argument goes that as social restrictions and voluntary social distancing are eased, this war chest will get spent, unleashing a tsunami of pent-up demand which will drive up inflation. But is this argument correct? Even if social restrictions do fully ease – a big if – is it correct to assume that unspent income will get spent? A recent study by the Bank of England points out that whether unspent income gets spent depends on whether households regard it as additional income or additional wealth.1 Whether unspent income gets spent depends on whether households regard it as additional income or additional wealth. The propensity to consume out of additional income is relatively high, with estimates ranging up to 50 percent. But the propensity to consume out of additional wealth is tiny, with international estimates centred around just 5 percent. This begs the question: will households regard the stimulus checks as additional income or additional wealth? The answer depends on whether the household has a low income or a high income. Lower income households, that have borne the brunt of job losses and furloughs, have suffered big drops in their income relative to consumption. Hence, they will regard the stimulus checks as additional income. But to the extent that the additional income is just (partly) replacing lost income, it will not boost their consumption versus what it would have been absent the lost income. On the other hand, higher income households and retirees have largely maintained their incomes while their consumption has fallen. This is where the surge in savings is concentrated. But not being ‘income or liquidity constrained’, these higher income households are more likely to deposit the stimulus checks into their savings accounts (or the stock market), regarding it as additional wealth. Hence, any boost to consumption will be modest and short-lived. In fact, this was precisely what happened after previous issues of stimulus checks, such as in 2008 and 2009. Stimulus checks had no meaningful impact on consumption or inflation trends (Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends A Major Anomaly In The Bond Market The recent surge in inflation expectations has moved in perfect lockstep with higher prices for commodities, especially crude oil. At first glance, this relationship seems intuitive. After all, we associate higher commodity prices with higher inflation. But on further thought, the tight positive correlation between inflation expectations and commodity price levels is counterintuitive. The first issue is basic maths. Inflation is a change in a price, so it should not move in lockstep with the level of any price. But there is a much bigger issue. Whether the commodity price is driving inflation expectations or whether inflation expectations are driving the commodity price, a higher price today will feed back into lower prospective inflation. In fact, a crude oil price above $50 has consistently predicted prospective deflation in the oil price, leading to CPI inflation underperforming its 2 percent target (Chart of the Week). The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The important takeaway is that the bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, but actual prospective inflation is negatively correlated with commodity prices (Chart I-3 and Chart I-4). Chart I-3The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... Chart I-4...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices This major anomaly in the bond market creates a great opportunity for long-term bond investors. When the (Brent) crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). And vice-versa when crude falls below $50. With Brent now at $68, the appropriate long-term stance is to overweight T-bonds versus TIPS (Chart I-5). Chart I-5When The (Brent) Oil Price Is Above , Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS There are also implications for other investors. Given that the bond market is useless at predicting inflation, it is also useless at assessing real interest rates. Specifically, when crude is above $50, the ex-post (realised) real bond yield will be higher than the ex-ante (assumed) real bond yield (Chart I-6). The important takeaway right now is that in any comparison with the real bond yield, equities and other risk-assets are even more expensive than they appear. Chart I-6When The (Brent) Oil Price Is Above , The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed Embrace The Fractal Market Hypothesis The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets, replacing the defunct Efficient Market Hypothesis (EMH). The breakthrough insight from the Fractal Market Hypothesis is that the market is not always efficient. The market is efficient only when a wide spectrum of investment time horizons is setting the price, signified by the market having a rich fractal structure. The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets. The corollary is that when the fractal structure becomes extremely fragile, it tells us that the information and interpretation of long-term investors is missing from the recent price setting, and is likely to reappear. At which point, the most recent price trend, fuelled by short-term groupthink, will break down. As most investors are unaware of the Fractal Market Hypothesis, it gives a competitive advantage to the few investors that do embrace it. Through the past five years, our proprietary Fractal Trading System has identified countertrend trading opportunities with truly excellent results. After 207 trades, the ‘win ratio’ stands at 61 percent. Yet as we understand more about this breakthrough theory of finance, we believe we can do even better. Today, we are very pleased to upgrade the trading system with innovations to the calculations of fractal structure, the countertrend profit opportunity, and the optimal holding period, all detailed in Box I-1. Box 1: Fractal Trading System Principles Countertrend opportunities in an investment will be identified by a fragile composite fractal structure, based on 65-day, 130-day, and 260-day fractal dimensions approaching their lower bounds. The countertrend profit target will be based on a Fibonacci retracement. There will be a symmetrical stop-loss. The maximum holding period will be trade-specific and vary from 33 to 130 business days (broadly 6 weeks to 6 months). From today, we will also identify a larger number of fragile fractal structures and especially highlight those that are evident in mainstream investments. From this shortlist of candidates, we will choose the most compelling to add into our portfolio. In many cases, the alignment of a fundamental argument with a fragile fractal structure will reinforce the investment case. Among our most recent recommendations, underweight China versus New Zealand achieved its 9 percent target, short Korean won versus US dollar achieved its 2.5 percent target, and long Russian rouble versus South African rand expired at 1.5 percent profit. This week, we highlight that the composite fractal structures of stocks versus bonds and the 30-year T-bond are becoming extremely fragile (Chart I-7 and Chart I-8). To be clear, this does not guarantee a countertrend move, but it does indicate an elevated susceptibility to a countertrend move. Hence, for the time being, we remain tactically neutral stocks versus bonds.  Chart I-7The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile Chart I-8The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile In the foreign exchange markets, we note that the strong advance in the Norwegian krone, fuelled by the rally in crude oil, is vulnerable to a pullback (Chart I-9). Accordingly, this week’s recommended trade is short NOK/PLN, setting a profit target and symmetrical stop at 2.6 percent. Chart I-9Short NOK/PLN NOK/PLN NOK/PLN   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Bank of England, An update on the economic outlook by Gertjan Vlieghe, 22 February 2021 Fractal Trading System A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Asset Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Equity Market Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market 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  

Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Data Can't Disappoint The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration.   The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Move Down In Quality Move Down In Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 5High-Yield Valuation High-Yield Valuation High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense.                           Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April Inflation Will Peak In April Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Price Pressures Are Building Price Pressures Are Building Chart 8Shelter Inflation About To Bottom Shelter Inflation About To Bottom Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS Stay Long TIPS Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3  With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification