Inflation

Highlights China’s economic recovery is in a later stage than the US. A rebound in US Treasury yields is unlikely to trigger upward pressure on government bond yields in China. Imported inflation through mounting commodity and oil prices should be transitory and does not pose enough risk for Chinese authorities to further tighten policies. Historically, Chinese stocks have little correlation with changes in US Treasury yields; Chinese equity prices are primarily driven by the country’s domestic credit growth and economic conditions. We maintain our tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations,  providing room for a cyclical upswing. Chinese offshore stocks, which are highly concentrated in the tech sector, are facing multiple challenges. We are closing our long investable consumer discretionary/short investable consumer staples trade and we recommend long A-shares/short MSCI China Index. Feature Chinese stocks extended their February losses into the first week of March. Market participants fear that escalating real government bond yields in the US and elsewhere will have a sustained negative impact on Chinese risk assets, reinforced by ongoing policy normalization in China. Global equity prices have been buffeted by crosscurrents. An acceleration in the deployment of vaccines and increased economic reopenings provide a positive backdrop to the recovery of corporate profits. At the same time, optimism about global growth and broadening fiscal stimulus in the US has prompted investors to expect higher policy rates sooner. The US 10-year Treasury yield is up by 68bps so far this year, depressing US equity valuations and sending ripple effects across global bourses. In this report, we examine how rising US and global bond yields would affect China’s domestic monetary policy and risk-asset prices.  Will Climbing US Treasury Yields Push Up Chinese Rates? Chart 1Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Increasing bond yields in the US will not necessarily lead to higher bond yields in China. Chart 1 shows that the direction of China’s 10-year government bond yield has a tight correlation with its US counterpart. It is not surprising because business cycles in these giant economies have become more synchronized. Interestingly, China’s 10-year Treasury bond yield has led the US one since 2015. This may be due to China’s growing importance in the world economy. China’s credit and domestic demand growth leads the prices of many industrial metals and in turn, business cycles in many economies. China’s rising long-duration government bond yields reflect expectations of an improving domestic economy, and these expectations often spill over to the rest of the world, including the US. Although the recent sharp rebound in the US Treasury yield is mainly driven by domestic factors, the rebound is unlikely to spill over to their Chinese peers, because the countries are in different stages of their business and policy cycles. America is still at its early stage of economic recovery and fresh stimulus measures are still being rolled out, whereas China has already normalized its policy rates back to pre-pandemic levels and its credit growth peaked in Q4 last year. Chinese fixed-income markets will soon start pricing in moderating growth momentum in the second half of this year, suppressing the long-end of China’s Treasury yield curve (Chart 2). Importantly, none of the optimism that has lifted US Treasury yields - a vaccine-led global growth recovery and a massive US fiscal stimulus – would warrant a better outlook for China. Reopening worldwide economies will likely unleash pent-up demand for services, such as travel and catering, rather than merchandise trade. Chart 3 shows that since the pandemic US spending on goods, which benefited Chinese exports, has soared relative to spending on services. The trend will probably reverse when the US and world economy fully opens, limiting the upside for China’s exports and its contribution to growth this year. Chart 2China And The US Are In Different Stages Of Their Economic Recoveries China And The US Are In Different Stages Of Their Economic Recoveries China And The US Are In Different Stages Of Their Economic Recoveries Chart 3US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic Bottom Line: China’s waning growth momentum will insulate Chinese bond yields from higher US Treasury yields.   Do Rising Inflation Expectations In The US Pose Risks Of Policy Tightening In China? Chart 4Imported Inflation Shouldnt Constrain The PBoC Imported Inflation Shouldnt Constrain The PBoC Imported Inflation Shouldnt Constrain The PBoC While China’s monetary policymaking is not entirely insulated from exogenous shocks, it is primarily driven by domestic economic conditions and inflation dynamics. We are not complacent about the risk of a meaningful uptick in global inflation, but we do not consider imported inflation a major policy constraint for the PBoC this year (Chart 4). Furthermore, at last week’s National People’s Congress (NPC), China set the inflation target in 2021 at 3%, which is a high bar to breach. Mounting commodity prices, particularly crude oil prices, may put upward pressures on China’s producer prices, but their impact on China’s overall inflation will be limited for the following reasons: China accounts for a large portion of the world’s commodity demand. Given that the country’s credit impulse has already peaked, domestic demand in capital-intensive sectors (such as construction and infrastructure spending) will slow this year. Reinforced policy restrictions on the property sector will also restrain the upside price potential in industrial raw materials such as steel and cement (Chart 5). For producers, the main and sustained risk for imported inflation will be concentrated in crude oil. The PPI may spike in Q2 and Q3 this year due to advancing oil prices and the extremely low base factor from the same period last year. The PBoC will likely view a spike in the PPI as transitory. Moreover, the recent improvement in producer pricing power appears to be narrow. The output price for consumer goods, which accounts for 25% of the PPI price basket, remains subdued (Chart 6). Chart 5Chinas Demand For Raw Materials Will Slow Chinas Demand For Raw Materials Will Slow Chinas Demand For Raw Materials Will Slow Chart 6Output Price For Consumer Goods Remains In Contraction Output Price For Consumer Goods Remains In Contraction Output Price For Consumer Goods Remains In Contraction Importantly, when oil prices plummeted in the first half of 2020, China’s crude oil inventories showed the fastest upturn on record (Chart 7). It suggests that China’s inventory restocking from last year may help to partially offset the impact from elevated oil prices this year. For consumers, oil prices account for a much smaller percentage of China’s CPI basket than in the US (Chart 8). Food prices, particularly pork, drive China’s headline CPI and can be idiosyncratic. We expect food price increases to be well contained this year due to improved supplies and the high base effect from last year.  Chart 7Massive Buildup in Chinas Crude Oil Inventory In 2020 Massive Buildup in Chinas Crude Oil Inventory In 2020 Massive Buildup in Chinas Crude Oil Inventory In 2020 Chart 8Oil Prices Account For A Small Portion In China's Consumer Spending Oil Prices Account For A Small Portion In Chinas Consumer Spending Oil Prices Account For A Small Portion In Chinas Consumer Spending Importantly, China’s inflation expectations have not recovered to their pre-pandemic levels and consumer confidence on future income growth also remains below its end-2019 figure (Chart 9). If this trend holds, then it will be difficult for producers to pass through escalating input costs to end users. Although China’s economy has strengthened, it is far from overheating (Chart 10). Without a sustained above-trend growth rebound, it is difficult to expect genuine inflationary pressures. The pandemic has distorted the balance of global supply and demand, propping up demand and price tags attached to it. In China’s case, however, production capacity and capital expenditures rebounded faster than demand and consumer spending, constraining the upsides in inflation (Chart 11).   Chart 9Consumer Inflation Expectations Have Not Fully Recovered Consumer Inflation Expectations Have Not Fully Recovered Consumer Inflation Expectations Have Not Fully Recovered Chart 10Chinese Economy Is Not Yet Overheating Chinese Economy Is Not Yet Overheating Chinese Economy Is Not Yet Overheating China’s CPI is at its lowest point since 2009, making China’s real yields much greater than in the US. Rising real US government bond yields could be mildly positive for China because they help to narrow the Sino-US interest rate differential and temper the pace of the RMB’s appreciation (Chart 12). A breather in the RMB’s gains would be a welcome reflationary force for Chinese exporters and we doubt that Chinese policymakers will spoil it with a rush to hike domestic rates. Chart 11And Production Has Recovered Faster Than Demand And Production Has Recovered Faster Than Demand And Production Has Recovered Faster Than Demand Chart 12Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Bottom Line: It is premature to worry about an inflation overshoot in China. The current environment is characterized as easing deflation rather than rising inflation. Our base case remains that inflationary pressures will stay at bay this year. Are Higher US Treasury Yields Headwinds For Chinese Stocks? Historically, Chinese stocks have exhibited a loose cyclical correlation with US government bond yields, particularly in the onshore market (Chart 13). Equity prices in China are more closely correlated with domestic long-duration government bond yields, but the relationship is inconsistent (Chart 14). Chart 13Chinese Stocks Have Little Correlation With US Treasury Yields Chinese Stocks Have Little Correlation With US Treasury Yields Chinese Stocks Have Little Correlation With US Treasury Yields Chart 14Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Chinese stocks are much more sensitive to changes in the quantity of domestic money supply than the price of money. A sharp rebound in China’s 10-year government bond yield in the second half of last year did not stop Chinese stocks from rallying. The insensitivity of Chinese stocks to changes in the price of money is particularly prevalent during the early stage of an economic recovery. As we pointed out in a previous report, since 2015 the PBoC has shifted its policy to target interest rates instead of the quantity of money supply. Thus, credit growth, which propels China’s business cycle and corporate profits, can still trend higher even as bond yields pick up. This explains why domestic credit growth, rather than China’s real government bond yields, has been the primary driver of the forward P/E of Chinese stocks (Chart 15A and 15B). This contrasts with the S&P, in which the forward P/E ratio moves in lockstep with the inverted real yield in US Treasuries (Chart 16). Chart 15ACredit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Chart 15BCredit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit growth in China peaked in Q4 last year and the intensity of the economic recovery has started to moderate. Hence, regardless of the changes in bond yields, Chinese stocks will need to rely on profit growth in order to sustain an upward trend (Chart 17). Chart 16Falling Real Rates Were Propping Up US Equity Valuations Falling Real Rates Were Propping Up US Equity Valuations Falling Real Rates Were Propping Up US Equity Valuations Chart 17Earnings Growth Needs To Accelerate To Support Chinese Stock Performance Earnings Growth Needs To Accelerate To Support Chinese Stock Performance Earnings Growth Needs To Accelerate To Support Chinese Stock Performance The good news is that recent gyrations in the US equity market, coupled with concerns about further tightening in China’s domestic economic policy have triggered shakeouts in China’s equity markets. The pullback in stock prices has helped to shed some excesses in frothy Chinese valuations and has opened a door for more upsides in Chinese stock on a cyclical basis. Bottom Line: Rising Treasury yields in the US or China will not have a direct negative impact on Chinese equities. Last year’s massive credit expansion has lifted both earnings and multiples in Chinese stocks and an acceleration in earnings growth is now needed to support stock performance. Investment Implications The key message from last week’s NPC meetings suggests that policy tightening will be gradual this year. While the 6% growth target was lower than expected, it represents a floor rather than a suggested range and it will likely be exceeded. Bond yields and policy rates are already at their pre-pandemic levels, indicating that there is not much room for further monetary policy tightening this year. The announced objectives for the fiscal deficit and local government bond quotas are only modestly smaller than last year. The economic and policy-support targets support our view that policymakers will be cautious and not overdo tightening. We will elaborate on our takeaways from this year’s NPC in next week’s report. Chart 18Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Meanwhile, there is still some room for Chinese cyclical stocks to run higher relative to defensives, given the current Goldilocks backdrop of global economic recovery and accommodative monetary policy (Chart 18). We maintain a tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. The market correction has not fully run its course. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. We are closing our long investable consumer discretionary/short investable consumer staples trade. Instead, we recommend the following trade: long A-share stocks/short MSCI China Index. Investable consumer discretionary sector stocks, which are concentrated in China’s technology giants, face a confluence of challenges ranging from the ripple effects of falling stock prices in the US tech sector and tightened antitrust regulations in China (Chart 19). In contrast, the A-share index is heavily weighted in value stocks while the MSCI China investable index has a large proportion of expensive new economy stocks (Chart 20). The trade is in line with our view that the investment backdrop has shifted in favor of global value versus growth stocks due to a strong US expansion, rising US bond yields and a weaker US dollar. Chart 19Chinese Investable Tech Sector Is Facing Strong Headwinds Chinese Investable Tech Sector Is Facing Strong Headwinds Chinese Investable Tech Sector Is Facing Strong Headwinds Chart 20Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Dear Client From March 18 I will be writing under a new product title, the BCA Research Counterpoint. The aim of the Counterpoint is to generate a high volume of investment opportunities that are unconnected to the business cycle and run counter to the conventional wisdom. For those of you that have followed the European Investment Strategy through the past ten years, Counterpoint will seamlessly continue the same intellectual framework of investment ‘mega-themes’, fundamental analysis, fractal analysis, and sector primacy. The difference is that the investment opportunities will encompass all geographies. To whet your appetite, early Counterpoint reports will introduce new investment mega-themes including: the compelling structural case for cryptocurrencies; why shocks such as the pandemic are inherently predictable; and the structural transformation coming to the global labour market. There will also be an upgrade of the proprietary Fractal Trading System to generate more ideas per week and to boost the win ratio towards 70 percent. As for the European Investment Strategy, it will continue in the very capable hands of my colleague and friend, Mathieu Savary. Mathieu has previously written the Foreign Exchange Service, the flagship Bank Credit Analyst, and most recently the Daily Insights. Moreover, Mathieu is French. So if anyone knows how Europe works (and doesn’t work), it is Mathieu! I do hope you read both products. Best regards Dhaval Highlights If bond yields continue their march higher, the most dangerous earthquake will happen in the global real estate market. If higher bond yields caused even a 10 percent decline in the $300 trillion global real estate market it would unleash a deflationary impulse equal to one third of world GDP This would make any preceding inflationary impulse feel like a waltz in the park. For long-term investors who can ride out near term pain, there are three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Feature Chart of the WeekThe Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy In the last couple of weeks, higher bond yields have caused tremors in the stock market. But if bond yields continue their march higher and stay there, the most dangerous earthquake will not happen in the stock market, it will happen in the real estate market. The $90 trillion worth of the global stock market is large, but it is chicken feed compared with the $300 trillion worth of global real estate (Chart of the Week). The big worry is that the valuation of global real estate is critically dependent on bond yields staying low. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of world GDP, would make any preceding inflationary impulse feel like a waltz in the park. Hence, to anybody worried that we are on the road to inflation, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate?1   The Real Risk Is Real Estate Over the past decade, global real estate rents have broadly tracked nominal GDP, as they should. But real estate prices have massively outperformed rents (Chart I-2). The reason is that the valuation paid for those rents has surged by 35 percent. This ‘multiple expansion’ of real estate which has added $80 trillion to global wealth – broadly equivalent to global GDP – is entirely due to lower bond yields. Chart I-2Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Within the global real estate market, the residential segment constitutes 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. It follows that the most important component of the real estate boom has been a housing boom. Given that most homes are owner-occupied, the boom in house prices has boosted the wealth of the ordinary global citizen by much more than the boom in stock prices. Moreover, the 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. Even Germany and Japan joined in, making it the most widely participated-in housing boom in economic history. What was behind this synchronised and broad-based housing boom? The answer is the universal decline in bond yields. As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields” In fact, as the US and China now dominate the global real estate market, the downtrend in the global rental yield has closely tracked the downtrend in the US and China long bond yields. The big danger would be if this downtrend turned into an uptrend, undermining the valuation of $300 trillion of global real estate. To repeat, even a 10 percent synchronised decline in global real estate prices would wipe out $30 trillion of global wealth equal to one third of annual GDP, and it would impact almost everybody. The ‘multiple expansion’ of real estate has added $80 trillion to global wealth, broadly equivalent to global GDP. But where is the pain point? Our answer is that if inflation fears lifted the average US and China 30-year bond yield to 3.75 percent (from 3 percent now), it would constitute the change in trend that would unleash a massive countervailing deflationary impulse from falling house prices (Chart I-3). Chart I-3Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Waiting For Rationality To Return To Stocks In the stock market, the August to mid-February period was a brief aberration in which stocks rallied in tandem with rising bond yields. But looking at the bigger picture, the bull market in stocks, just as for real estate, is due to lower bond yields (Chart I-4). Chart I-4The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration Since 2008, global stock market profits have gone nowhere. Therefore, the only reason that the stock market surged is that the valuation paid for those unchanged profits surged. Just as for real estate, the stock market’s valuation surged because bond yields collapsed (Chart I-5). Chart I-5The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations Taking account of this downtrend in bond yields, the post-2008 boom in valuations is rational. However, as we warned two weeks ago, the continued expansion of valuations while bond yields are backing up means that The Rational Bubble Is Turning Irrational. The point of vulnerability is in high-flying tech stocks. Since 2009, the technology sector earnings yield has always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of the rational bubble. But in recent weeks, this envelope has been breached, indicating that valuation is entering a new and irrational phase (Chart I-6). Chart I-6The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational For long-term investors the pressing questions are: how much higher can bond yields go, and for how long? Our answers are, much less than 1 percent, and not for long – because the deflationary impact on $300 trillion of real estate would eventually force bond yields into a very sharp reversal. The Road To Inflation Ends At Deflation Many people believe that ‘real’ assets such as real estate and stocks perform well in an inflationary scare. But this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income collapses, taking the price of the asset down with it. From the state of price stability, in which most developed economies now find themselves, the creation of inflation is a non-linear phenomenon. Non-linear means that policymakers’ efforts result in either nothing (witness Japan or Switzerland), or in uncontrolled inflation (witness the US in the late 1960s). In fact, can you name any economy that has shifted from price stability to a controlled inflation? If you can, please tell me in an email! When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. This is because the starting valuation needed to generate a given real return during uncontrolled inflation is much lower than during price stability. When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. Chart I-7 should make this crystal clear. During the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But during the uncontrolled inflation of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to sink to 7. This explains why the prices of stocks and real estate collapsed in the 1970s and why they would collapse again in a new inflationary scare. Chart I-7In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return As an aside, this also explains why so-called ‘financial repression’ – whereby the central bank holds down bond yields while the government generates inflation – will not work. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of stocks and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the valuation of such assets would collapse to generate the previously required real return – the result being an almighty crash in stock and real estate prices. Given that the combined value of such markets dwarfs the $90 trillion global economy, the road to inflation would end at deflation. For long-term investors who can ride out near term pain, all of this leads to three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Fractal Trading System* In a very successful week, short MSCI Korea versus MSCI AC World achieved its 10.6 percent profit target and short tin versus lead quickly achieved its 13 percent profit target. This takes the rolling 12-month win ratio to 60 percent. Given the transition to the new product title, there are no new trades this week. We look forward to introducing the upgraded Fractal Trading System and some new trades in the BCA Counterpoint on March 18. Chart I-8MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills Prime Index: World Cities, August 2020; and Savills: 8 things to know about global real estate value, July 2018. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights GameStop & Bond Yields: The reflationary conditions that helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Remain overweight the latter versus the former. Italy: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year. Feature Dear Client, The next Global Fixed Income Strategy publication will be a Special Report on Canada, jointly published with our colleagues at Foreign Exchange Strategy on Friday, February 12. We will return to our regular publishing schedule on Tuesday, February 16. Rob Robis, Chief Global Fixed Income Strategist Chart of the WeekExpect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness The “Reddit Retail Revolution” has exposed the dangers of staying too long in crowded short positions for equities like GameStop, but bond markets were unfazed by the wild moves in stocks last week. US Treasury yields actually crept upwards as the mother of all short squeezes became the top news story in America. Corporate credit spreads worldwide were essentially unchanged, despite the pickup in US equity volatility measures like the VIX. Bond investors recognize that, while the sideshow of rebel traders taking on mighty hedge funds makes for great theater, the underlying reflationary global policy backdrop remains the main driver of global bond yields and credit risk premia (Chart of the Week). Global fiscal policy risks are increasingly tilted towards more stimulus than currently projected, even as the pace of new COVID-19 cases is starting to slow in the US and much of Europe. Vaccine rollouts in many countries are going far slower than expected, which has forced global central banks to commit to maintaining highly accommodative policies - zero interest rates, quantitative easing (QE) and cheap bank funding – for longer. As Fed Chair Jerome Powell noted in his press conference following last week’s FOMC meeting, “There’s nothing more important to the economy now than people getting vaccinated.” Chart 2Vaccine Rollout Critical For Fed/ECB/BoE Policy The Revolution Will Be Monetized The Revolution Will Be Monetized On that front, the largest economies on both sides of the Atlantic continue to perform poorly. According to data from the Duke Global Health Innovation Center, vaccination coverage (defined as actual vaccination doses acquired on a per person basis) in the US, UK and European Union remains low relative to the intensity of COVID-19 cases within the population (Chart 2) – especially compared to the experience of other major Western countries.1 As we discussed in last week’s report, it is far too soon for investors to fear a hawkish move by global central banks towards tapering asset purchases and signaling future interest rate hikes.2 The GameStop episode may cause some policymakers to worry about the financial stability risks resulting from cheap money policies, but not before the greater risks to global growth from the COVID-19 pandemic are contained. Until vaccination rates rise to levels where there is the potential for herd immunity to be reached, central banks will have little choice by to maintain 0% (or lower) policy rates for longer with continued expansion of their balance sheets (Chart 3). Policy makers will even likely respond with more QE in the event of broad financial market turmoil occurring before inflation expectations return to central bank targets (Chart 4). Chart 3Expect More Global QE ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 4...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields We continue to recommend the following medium-term positioning for reflation-based themes in global fixed income markets: below-benchmark overall duration exposure, favoring lower-quality corporate bonds versus government debt, and underweighting US Treasuries within global government bond portfolios. Bottom Line: The reflationary conditions that have helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Italy: ECB Policy Trumps Political Uncertainty One of our highest conviction fixed income investment recommendations over the past year has been to overweight Italian government bonds (BTPs). We have maintained that bullish stance with an expectation that Italian bond yields (and spreads over German debt) would converge to the levels of Spain, restoring a relationship last seen sustainably in 2016 (Chart 5). Chart 5A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty The recent collapse of the coalition government of Prime Minister Giuseppe Conte would, in a more “normal” time, represent a serious threat to the stability of the Italian bond market and our bullish view. Yet the response so far has been muted, with the spread between 10-year BTPs and German Bunds up only 11bps from the mid-January lows. The current political drama stemmed from a disagreement within the ruling coalition over how the government was planning to use Italy’s share of the €750bn EU Recovery Fund. As we go to press, the survival of the current government hangs in the balance, with President Sergio Mattarella testing whether the political parties can form a government with a majority. The initial announcement of that Recovery Fund was considered to be a major reason for a reduced risk premium on Italian government bonds, as it represented a potential step towards greater fiscal integration within Europe. Unfortunately, it took the COVID-19 crisis to get the rest of Europe to offer help to the more economically fragile countries like Italy. The country suffered one of the world’s worst initial waves of the virus and the late-2020 surge has also hit hard – although, more recently, Italy has fared far better than Southern European neighbors Spain and Portugal with a slower pace of new cases and hospitalizations (Chart 6). Italy’s economy has struggled under the weight of some of the most stringent restrictions on activity within Europe to stop the spread of the virus, according to the Oxford COVID-19 database (Chart 7). Domestic spending on retail and recreation activities is estimated to be down nearly 50% from the start of the pandemic, a hit to the economy made worse by the collapse of tourism revenue that will take years to fully recover. In other words, Italy desperately needs the money from the EU Recovery Fund. Chart 6Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Chart 7A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 Former Prime Minister Matteo Renzi and his Italia Viva party precipitated the crisis by withdrawing their support from Conte’s coalition, but are in a weak position electorally. They claim that the funds should be handled by parliament, rather than a technocratic council overseen by Conte, and devoted to long-term structural reform rather than short-term fixes. Renzi’s withdrawal from the ruling coalition, however, is not grounded in substantial disagreements over fiscal spending: First, the EU recovery fund requires all member states to use 30% of the funds on climate change initiatives and 25% on digitizing the economy, and none of the major parties oppose this use of the €209 billion coming their way. Second, Prime Minister Conte adjusted his spending plans, nearly doubling the allocations for health, education, and culture, in response to Renzi’s criticisms that not enough spending focused on structural needs. Third, Renzi wants to tap €36 billion from the European Stability Mechanism in addition to taking recovery funds, but this would come with austerity measures attached (which is self-defeating) and would be opposed by the left-wing populist Five Star Movement, a linchpin in the ruling coalition. Even if the immediate political turmoil passes, there will still be an elevated risk of an early election as the various parties jockey for power in the wake of the cataclysmic pandemic, and as they eye control of the presidency, which is up for grabs in 2022. The only real change on the fiscal front would come if the populist League and Brothers of Italy ended up winning a majority and control of government in the eventual elections, as they favor much greater fiscal largesse. It is possible that Conte will survive as his personal support has increased throughout the crisis. Otherwise, former ECB President Mario Draghi could replace him, although he is now less popular than Conte. President Mattarella is not eager to dissolve parliament given that the combined strength of right-wing anti-establishment parties is greater than that of the centrist and left-wing parties in the ruling coalition judging by public opinion polls (Chart 8). Yet sooner rather than later, a new election looms. The country already completed an electoral reform via a referendum in September 2020 that cleared the way for a new election to be held. Chart 8Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Chart 9Waning Immigration Undercuts Italian Populists (For Now) The Revolution Will Be Monetized The Revolution Will Be Monetized The current crisis is different than past bouts of Italian political uncertainty as there is less of a question over Italy’s commitment to the euro - which in the past has resulted in higher Italian bond yields and wider BTP-Bund spreads as markets had to price in euro breakup risk. The current coalition, and any new coalition cobbled out of the current morass to prevent a snap election, are united in their opposition to the populist League and the Brothers of Italy. They will strive to remain in power to distribute the EU recovery funds and secure the Italian presidency for an establishment political elite – one, like Mattarella, who will act as a check on the power of any future populist government and its cabinet choices, just as Mattarella himself hobbled the League’s most radical proposals from 2018-19. Chart 10Italian Support For EU & The Euro Sufficient But Not Ironclad The Revolution Will Be Monetized The Revolution Will Be Monetized While the right-wing “sovereigntist” parties lead in the opinion polls, the League has lost support since its leader Matteo Salvini’s failed bid to trigger an election in August 2019 and especially since the COVID-19 outbreak has boosted the establishment parties and coalition members. Anti-immigration sentiment, a key support of this faction, has subsided as the EU has cut down the influx of immigrants (Chart 9). Salvini and his supporters have also compromised their euroskepticism to appeal to a broader audience as 60% of the populace still approves of the euro – although this support is falling again and bears monitoring (Chart 10). Another economic shock or a new wave of immigration could put the right-wing populists into power. Moreover, an unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. Thus, the risk of euroskepticism and fiscal populism will persist over the coming two years, even though they are most likely contained at the moment. Has The ECB Removed The Tail Risk Of BTPs? The ECB has shown they are willing to use their balance sheet via QE and cheap bank funding tools like TLTROs to support the euro area’s weakest link – Italy. Thus, any upward pressure on Italian bond yields/spreads from the current political fracas will almost certainly be met by a more aggressive ECB response (more QE for longer, new TLTROs), limiting the damage to the Italian bond market. Chart 11What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? The ECB’s TLTROs appear to have been helpful for Italy, whose LTRO allotments represent 14.7% of total bank lending (Chart 11). Yet Spanish banks have relied on cheap ECB funding to a similar degree, while the growth of bank lending in Italy has substantially lagged that of Spain since the start of the pandemic in 2020 – even with Italy having less restrictive lending standards according to the ECB’s Bank Lending Survey. The ECB has also helped Italy by being more flexible with its purchases of Italian government bonds within both the Public Sector Purchase Program (PSPP) and the Pandemic Emergency Purchase Program (PEPP) that began in response to COVID-19. ECB data show that, after the worst days of the COVID-19 market rout last spring when the 10-year Italian bond yield soared from 1% to 2.4% over just three weeks, the ECB increased the Italy share of its bond buying to levels well above the Capital Key weighting scheme that “officially” governs the bond purchases. This was true within both the PSPP (Chart 12) and the PSPP (Chart 13). Chart 12ECB Paying Less Attention To The Capital Key In The PSPP ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 13… And The PEPP The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 14Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds The ECB’s actions helped stabilize Italian bond yields, sowing the seeds of the major decline in yields that took place between April and September. Once Italian bond yields fell back to pre-pandemic levels, the ECB slowed the pace of its purchases of Italian bonds to levels at or below the Capital Key weights. Thus, the ECB was willing to deviate from its own self-imposed rules for its bond purchase schemes in order to ease financial conditions in Italy during a pandemic. There is no reason to believe that would not occur again if yields rise because of a growing political risk premium while the pandemic was still raging. A prolonged period of political uncertainty in Italy, especially one that ends with fresh elections, could even force the ECB to maintain or extend its full current mix of policies and not just QE. For example, a new TLTRO could be initiated later this year, or the subsidized cost of banks borrowing from existing TLTROs could be reduced further, all in an effort to help boost Italian lending activity. More likely, the PEPP could be expanded in size or extended beyond the current March 2022 expiration, or the PSPP could be upsized to allow for more purchases of Italian debt (Chart 14). From an investment strategy perspective, there is still a strong case for overweighting Italian government bonds in global fixed income portfolios, even with the current political uncertainty. The weight of ECB policy actions removes much of the usual upside risk to BTP yields. However, investors will likely be more reluctant to drive Italian yields (and spreads versus Germany) to fresh lows if there is a risk of early elections, as we expect. Italian bonds are now more of a pure carry with yields trapped between politics and QE, but that still justifies an overweight stance - especially given the puny levels of alternative sovereign bond yields available elsewhere in the euro area. Bottom Line: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The Duke Global Health Innovation Center data on COVID-19 can be found here: https://launchandscalefaster.org/COVID-19. 2 Please see BCA Research Global Fixed Income Strategy Report, "A Pause, Not A Peak, In Global Bond Yields", dated January 26, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Revolution Will Be Monetized The Revolution Will Be Monetized Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 17The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 18The Case For US Inflation The Case For US Inflation The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China No Inflation In China No Inflation In China Chart 27No Inflation In China No Inflation In China No Inflation In China Chart 28No Inflation In China No Inflation In China No Inflation In China Chart 29No Inflation In China No Inflation In China No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 36Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 38A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 39A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 40A Mania In Full Force A Mania In Full Force A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 45Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks Chart 62The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Productivity Growth Estimates For EM/China Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Productivity Is Ultimately Reflected In Rising Real Income Per Capita Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation China: Strong Productivity Growth Has Kept A Lid On Inflation China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Faster Productivity Growth = Wider Corporate Profit Margins Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains China and Vietnam: Rising Export Market Share Reflects Productivity Gains China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity A Primer On Productivity A Primer On Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over US Equity Outperformance Is Over US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In   In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples EM Equity Multiples EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples   In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks   A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature Feature ChartEconomies Have Already Snapped Back Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views In this final report of a tumultuous 2020, we present our key views for 2021 in the form of ten questions and answers during a recent conversation with a client. 1.  Let’s begin with a blunt question. How can your views ever anticipate a shock such as this year’s once-in-a-century pandemic? Nobody can predict when, where, or how a shock will come. But what we can, and should, always do is gauge the fragility of the market to an incoming shock, whatever that unknown shock might be. Before the pandemic struck, both our 2020 key views and our first report of this year, Markets Are Fractally Fragile, pointed out that a fragile market was vulnerable to “the tiniest of straws that could break its back.” Right now, markets are close to a similar point of fragility. 2.   What is the specific source of market fragility right now? The fragility is that tech stock valuations have become hyper-dependent on low bond yields in a so-called ‘rational bubble’. Specifically, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous fragilities in February 2018, October 2018, April 2019, and January 2020 (Chart I-2). Chart I-2Tech Stock Valuations Are Fragile Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views These previous fragilities resulted in an exhaustion, or worse, a correction, in tech stocks, and by extension in the overall market. The upshot is that a meaningful rise in bond yields could once again undermine the stock market. 3.   But I thought that higher bond yields were good for stocks, if the higher bond yields imply that growth is accelerating? Not necessarily. Yes, a stock price is proportional to growth, but it is also inversely proportional to the discount rate, which is the required return that investors demand to hold it. If the discount rate increases by more than growth, then the stock price will fall, not rise. The discount rate equals the bond yield plus the equity risk premium. At ultra-low yields, the two components move together. This is because when the bond yield declines towards its lower bound, the bond price carries less upside versus downside and thereby more risk. Meaning that in relative terms, equities require a smaller risk premium. When bond yields increase, the opposite is true – both the bond yield and the equity risk premium rise together (Chart I-3). Chart I-3AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart I-3BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views     The result is that growth would have to increase very sharply to counter the large rise in the bond yield plus equity risk premium. 4.   But 2021-22 are likely to be years of very strong growth just like the post-recession years 2009-10, right? Wrong. You see, after a slump the strongest growth occurs in the sharp snapback of lost output, and most of this sharp snapback has already happened. In 2008-09, the US and German economies shrank for four quarters. It then took five quarters of strong growth to recover two-thirds of this lost output. But in 2020, everything has happened at quintuple-speed. It has taken just one quarter to recover two-thirds of the lost output, and by the end of this year US GDP will be almost back to its pre-pandemic level (Feature Chart and Chart I-4). Chart I-4Economies Have Already Snapped Back Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views This is because we quickly realised that even in a full-scale pandemic, 90 percent of economic activity can continue with face masks and social distancing. The activities that are most disrupted – retail, hospitality, and transport – account for just 10 percent of output. Meanwhile, China, which on some measures is the world’s largest economy, is already ‘back to normal’ because its effective track-and-trace system has circumvented the need for face masks and social distancing. The upshot is that, as far as global economic output is concerned, most of the powerful snapback has already happened. 5.   But if economic output has largely recovered, why does it not feel like it has? For three reasons. First, the most disrupted activities comprise so-called ‘social consumption’ such as going to bars and restaurants, having friends round for dinner, and going on holiday. In other words, all the fun things in life. Although these activities account for just 10 percent of economic output, they likely account for a much bigger proportion of our happiness. Second, we are producing and consuming the 90 percent of undisrupted output differently. For example, working from home, doing business meetings virtually, and doing our shopping on-line. Crucially, much of this ‘new-normal’ is here to stay even when the pandemic ends. Third, although the disrupted activities account for just 10 percent of output, they account for a very significant 25 percent of all jobs. Meaning that the jobs market has not snapped back to the same extent as output. Indeed, permanent unemployment continues to rise (Chart I-5). Chart I-5Permanent Unemployment Continues To Rise Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Alas, the jobs market will take a long time to fully recover even when the pandemic ends. This is because the new-normal way of producing and consuming will permanently scar traditionally high-employment sectors such as retail and hospitality. Constituting a major economic fragility in the new-normal (Table I-1). Table I-1Retail And Hospitality Employ 25 Percent Of All Workers Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views 6.   All of which means inflation stays below the 2 percent target, right? Right. But your question should be framed differently. You see, inflation is a non-linear system with two states: price stability and price instability. You can shift an economy between these two states, but you cannot hit an arbitrary target like 2 percent, 3 percent, or 5 percent. So, your question should be, will developed economies stay in the state of price stability? And the answer is yes, because it is the much better state to be in, and it took decades of blood, sweat and tears to achieve. Nevertheless, any government can flip its economy into the state of price instability if it so desires. Just look at Turkey. A warning sign is that the central bank loses its independence, enabling it to monetise government debt. That’s the warning sign to look out for. 7.   Talking of fragility in a new-normal, hasn’t the double whammy of Brexit and the pandemic weakened the EU? No, quite the contrary. As Jean Monnet, a founding father of the EU, said: “Europe will be forged in crises.” And he was right. Each of the last three crises has strengthened the EU’s architecture. The euro debt crisis added the missing ‘lender of last resort to sovereigns’ weapon into the ECB armoury – a weapon whose mere presence means it has never had to be used. Brexit removed the most troublesome member from the EU fold, as well as demonstrating how costly it is to exit. And the pandemic has allowed the EU to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. All of which means that the yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately disappear altogether (Chart I-6). Chart I-6The Yield Spread On Euro Periphery Bonds Will Vanish Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views 8.   What about the prospects for the UK outside the EU? Like all divorces, Brexit is a gain of self-determination for a loss of wealth. Hence, since the Brexit vote in 2016, the UK economy has flipped from outperformer to underperformer (Chart I-7). Chart I-7The UK Economy Has Flipped From Outperformer To Underperformer Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views The UK economy will continue to underperform until it forges a fresh purpose and role as a newfound singleton on the world stage. 9.   Turning to investments, will the 2020 losers become the 2021 winners, and vice-versa? No, that’s an over-simplification. For example, for bonds to lose their 2020 winnings, yields would have to back up a lot. But as we’ve already discussed, that would burst the ‘rational bubble’ in tech stocks, undermine the stock market, and put renewed downward pressure on bond yields. In which case, banks will struggle to sustain any outperformance (Chart I-8). Meaning that ‘value’ will struggle to sustain any outperformance. Hence, a much smarter strategy is to switch between winners and losers within ‘growth’ and within ‘value’. Specifically, overweight healthcare versus tech, and overweight utilities versus banks. Chart I-8Bank Relative Performance Tracks The Bond Yield Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Of course, sector allocations always carry implications for regional and country equity allocation. The main implications are to overweight Europe versus Emerging Markets (Chart I-9), and to overweight Developed Markets versus Emerging Markets. Chart I-9Europe Vs. EM = Healthcare Vs. Tech Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views 10. Finally, what about your long-term recommendations? This brings us full circle to the first question. While we could not predict the pandemic, all our four mega-themes for the 2020s proved to be successful, and in some cases very successful. A hypersensitivity to higher interest rates. Overweight equities versus bonds. Europe conquers its disintegration forces. Overweight European currencies. Non-China exposed investments outperform. Underweight materials and resources. The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Given their long-term nature, these structural recommendations are as appropriate today as they were a year ago. And with that, it is time to sign off on a tumultuous 2020 and usher in 2021, a year which we define as Fragility In A New-Normal. We wish you and your families a safe and healthy holiday season, and a less tumultuous 2021. Fractal Trading System* This week’s recommended trade is to go long US utilities (XLU) versus US materials (XLB). Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short European retail (EXH8) versus the market (STOXX) achieved its 4.2 percent profit target at which it was closed. The rolling 12-month win ratio now stands at 61 percent. Chart I-10 Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-2Indicators To Watch - Bond Yields Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-3Indicators To Watch - Bond Yields Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-4Indicators To Watch - Bond Yields Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-6Indicators To Watch - Interest Rate Expectations Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-7Indicators To Watch - Interest Rate Expectations Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views Chart II-8Indicators To Watch - Interest Rate Expectations Fragility In A New-Normal: 2021 Key Views Fragility In A New-Normal: 2021 Key Views  

This week, we present the BCA Central Bank Monitors Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions. The Chartbook has previously been published by BCA Research Global Fixed Income Strategy but, starting today, will be jointly published with BCA Research Foreign Exchange Strategy twice per year.  Given how expectations of monetary policy changes influence both bond yields and currencies, we see the Chartbook as a useful forum for cross-market analysis of fixed income and foreign exchange. We have Monitors for ten major developed market economies and, currently, all are below the zero line, indicating the need for continued easy global monetary policy (Charts 1A & 1B). The Monitors are all trending higher, however, as global growth and financial markets have steadily recovered from the brutal collapse spurred by the first wave of COVID-19 earlier this year. The recovery in the Monitors is consistent with two of BCA’s highest conviction views for 2021 – rising global bond yields, led by the US, but with additional weakness in the counter-cyclical US dollar. The compression in the US interest rate advantage this year is sufficient to allow for some upside, without derailing the dollar bear market. Chart 1ALess Easy Money Required... Less Easy Money Required... Less Easy Money Required... Chart 1B...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels   An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data that have historically been correlated to changes in interest rates.  The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors.  Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). Chart 2AA Rebound In Our CB Monitors... A Rebound In From Our CB Monitors... A Rebound In From Our CB Monitors... Chart 2B...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar.  We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Previously, the country coverage for the Monitors has included the US, euro area, UK, Japan, Canada, Australia, New Zealand and Sweden. In this report, we introduce new Monitors for Norway and Switzerland – countries with relatively small government bond markets but with actively traded currencies.  We have also revamped the individual component lists of the existing Monitors to include a broader range of economic and inflation data, as well as adding more measures of financial conditions like equity prices or corporate credit spreads. The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates.  Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). None of the Monitors is indicating a need for policymakers to turn more hawkish. At the moment, the common signal from the Monitors is that there is diminished pressure to ease global monetary policies compared to mid-2020. At the same time, none of the Monitors is indicating a need for policymakers to turn more hawkish. There are growing divergences between the individual Monitors, though, which are creating more interesting opportunities for relative bond and currency trades and portfolio allocations – as we discuss throughout the pages of this Chartbook. Fed Monitor: Less Pressure For More Easing Our Fed Monitor has rebounded sharply during the latter half of 2020 on the back of improving US economic growth momentum and booming financial markets. However, it is not yet signaling a need for the Fed to begin moving to a less accommodative policy stance (Chart 3A).    The US economy has recovered impressively from the COVID-19 recession, with real GDP expanding at an annualized 33% pace in Q3 and the ISM Manufacturing index reaching a two-year high in October. Rapid growth also fueled a recovery in the labor market, with the US unemployment rate falling from a peak of 14.7% in April to 6.7% in November. It will take a few years for the US economy to return to full employment, given the severity of this year’s recession. The IMF estimates that the US output gap will not be effectively closed until 2023, thus a sustained return of US inflation to the Fed’s 2% target will take time to develop (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BAn Improving US Economic Backdrop BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 3CThe US Dollar Is Countercyclical The US Dollar Is Countercyclical The US Dollar Is Countercyclical The recovery in the Fed Monitor has been led primarily by the financial and growth components (Chart 3C). The inflation components will be more relevant to time the start of the Fed’s next rate hiking cycle. The Fed’s recent shift to an Average Inflation Targeting framework means that US monetary policy will not be tightened based on a forecast of higher inflation, as the Fed has done in past cycles. This means that both US growth and inflation will be allowed to accelerate in 2021 without a pre-emptive hawkish response from the Fed. The result: additional downward pressure on the counter-cyclical US dollar, which tends to weaken when the Fed Monitor is rising (bottom panel). The current surge in US COVID-19 cases represents a near-term downside risk to US growth momentum, as evidenced by a string of softer data prints in November.  Another round of fiscal stimulus and, more importantly, the start of the vaccine distribution process will give a bigger lift to economic confidence and growth – and US bond yields - in the first half of 2021.  We recommend an underweight strategic allocation to US Treasuries within global government bond portfolios (Chart 3D). Chart 3DUpside For Treasury Yields Upside For Treasury Yields Upside For Treasury Yields BoE Monitor:  Subdued Inflation Requires A Dovish Stance Our Bank of England (BoE) Monitor has rebounded sharply from the Q2 collapse, but remains well below zero indicating the ongoing need for easy UK monetary policy (Chart 4A). To that end, the BoE increased the size of its Gilt quantitative easing (QE) program by £150bn last month. However, the central bank chose to not cut the Bank Rate from 0.1% into negative territory, despite many public flirtations with such a move by BoE officials in recent months. Both the output gap and unemployment gap show high levels of excess capacity in the UK economy that are projected to take years to unwind according to the IMF and OECD (Chart 4B). UK real GDP grew by 15.5% on a quarter-on-quarter basis in Q3, a big reversal from the -19.8% plunge in Q2, but more recent domestic data has softened with the UK under national lockdowns to fight a surge in COVID-19 cases. UK headline CPI inflation is threatening to dip into deflation, even with a soft pound. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUK Excess Capacity Will Take Years To Unwind BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 4CLingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Looking at the details of our BoE Monitor, all three main sub-components remain below the zero line, but with some diverging trends (Chart 4C). The inflation components remain very weak, but the growth components have almost rebounded back to the pre-pandemic level. The financial components have also recovered sharply thanks in no small part to the BoE’s highly accommodative monetary policy. The BoE Monitor has historically been positively correlated to the momentum of the UK currency, and the trade-weighted pound appears to have outperformed the weakness in the Monitor (bottom panel). The near term direction of the pound, however, is completely linked to the final stage of the UK-EU Brexit negotiations. A no-deal Brexit would likely see the gap between the momentum of the pound and our BoE Monitor close via a sharp fall in the currency.  If a trade agreement is reached, however, we would expect the convergence to happen via a rising Monitor catching up to a firming currency, driven by a likely improvement in portfolio inflows. With COVID-19 vaccines already starting to be administered in the UK, a “peaceful” resolution to the Brexit saga could give the UK economy a solid lift in 2021 – especially with the UK government preparing a big fiscal impulse.  Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields. Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields (Chart 4D). Given the lack of UK inflation, and with the BoE taking down a large share of new Gilt issuance via QE, UK bond yields will lag the rise in global bond yields that we expect in the first half of 2021, even if there is good news on Brexit. We continue to recommend an overweight stance on UK Gilts. Chart 4DExpect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise ECB Monitor: Price Deflation Leads To Asset Reflation Our European Central Bank (ECB) Monitor is in “easy money required” territory, but has rebounded significantly from the lows seen earlier in 2020 (Chart 5A). The ECB delivered on that easing message at the December policy meeting, increasing the size of its Pandemic Emergency Purchase Program by €500bn to €1.85tn and extending the end-date of the program from June 2021 to March 2022.  The central bank also extended the maturity date for its offer of heavily discounted funding (at rates as low as -1%) for bank lending to June 2022. The ECB needed to deliver another round of easing because the euro area has fallen back into deflation. Year-over-year headline CPI inflation reached -0.3% in November, while core inflation was not much further behind at +0.2% (Chart 5B). With much of Europe now under increased economic restrictions due to the latest surge in COVID-19 cases, the near-term downside risks to euro area growth could push inflation even deeper into negative territory in the coming months. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BLots Of Slack In The Eurozone BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 5CThe Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy Looking at the breakdown of our ECB Monitor, there is a very large divergence between the components. The inflation components are at the most depressed levels since the turn of the century, while the growth components have rebounded sharply (Chart 5C). The financial conditions components have now surged above the zero line, suggesting pressure on the ECB to tighten policy from robust European financial markets. Of course, booming markets are a direct result of the ECB’s dovish monetary stance, which includes the rapid expansion of its balance sheet and significant purchases of riskier sovereign bonds in Italy, Spain and even Greece.  The ECB realizes that it cannot cut policy interest rates any further into negative territory without harming the ability of the fragile European banking system to earn profits.  This effective floor on nominal policy rates, combined with deepening price deflation, has boosted real European interest rates.  The result is a steadily climbing euro, even as the ECB has continued to signal a continued dovish policy bias and an aggressive expansion of its balance sheet.  The weakening trend for the US dollar that we expect in 2021 will leave the ECB little choice but to continue doing what it has been doing – more asset purchases, more cheap funding for bank lending and extending the time duration of all its easing programs in an effort to keep European financial markets aloft while also limiting the damage from an appreciating euro.  The introduction of a COVID-19 vaccine should provide a lift to growth, but inflation is likely to remain very subdued without a weaker euro. Inflation is likely to remain very subdued without a weaker euro. The depressed level of the ECB Monitor suggests that there is additional scope for lower euro area bond yields (Chart 5D), although the impact will not be the same for all countries in the region.  Deeply negative German and French bond yields will likely not decline much in 2021, although they will not rise much either even as US Treasury yields move higher, making them good defensive overweights in a global bond portfolio. At the same time, Italian and Spanish bond yields will continue to grind lower as ECB buying and more European fiscal co-operation help further reduce the risk premium on Peripheral Europeans - stay overweight. Chart 5DEuropean Yields Should Lag The US European Yields Should Lag The US European Yields Should Lag The US BoJ Monitor:  Fighting Deflation, Once Again Our Bank of Japan (BoJ) Monitor has rebounded from the recent low but is still well below zero, indicating that easier monetary policy is required (Chart 6A). That will be hard for the BoJ to deliver, however - policy rates are already negative, the BoJ’s balance sheet has blown up to 128% of GDP, and a more dovish forward guidance is impossible as most market participants already believe the BoJ will keep rates untouched for years. Japan’s economic recovery is currently at near-term risk from a particularly sharp increase in COVID-19 cases, although Japan’s labor market did not suffer much from the pandemic-induced plunge in growth earlier this year (Chart 6B). Nonetheless, while the unemployment rate remains below the OECD’s estimate of full employment (4.1%), there remains significant excess capacity in Japan according the IMF output gap estimates, with headline CPI inflation now in mild deflation. Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BSignificant Excess Capacity In Japan BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 6CJapanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions The individual elements of the BoJ Monitor show a large divergence between the growth and inflation components, which are very depressed, and the more stable financial component (Chart 6C). The latter reflects the outstanding performance of Japanese equities in recent months, with some benchmark indices reaching levels last seen in the mid-1990s. The continued steady expansion of the BoJ’s balance sheet is clearly helping to underwrite easy financial conditions in Japan. While the BoJ is reaching some operational constraints with its asset purchases, owning nearly one-half of all JGBs and three-quarters of all Japanese equity ETF’s, the central bank has no choice but to continue buying assets to support financial conditions. Cutting policy interest rates deeper into negative territory is a non-starter given the negative impact sub-0% rates have had on the profitability of Japanese banks. The inability of the BoJ to further ease Japanese monetary policy is boosting real rates and supporting the yen. The historical correlation between the BoJ Monitor and the yen has not been as consistent as that seen in other countries, but since the 2008 financial crisis a deteriorating BoJ Monitor has tended to coincide with a rising yen – given the lower bound of policy rates.  The inability of the BoJ to further ease Japa-nese monetary policy is boosting real rates and supporting the yen.  The weakness of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should fall significantly (Chart 6D). However, the BoJ’s Yield Curve Control policy, with the central bank buying enough bonds to keep the 10yr JGB yield around 0%, is preventing JGB yields from plunging to the deeply negative yield levels seen in core Europe. This policy-induced stability of Japanese yields actually makes JGBs a defensive bond market when US Treasury yields are rising. Thus, we recommend an overweight stance on JGBs given our view that US bond yields have more upside. Chart 6DPolicy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable BoC Monitor:  No Choice But To Stay Ultra-Dovish Our Bank of Canada (BoC) Monitor has seen a much weaker rebound off the lows than some of our other Central Bank Monitors, indicating that the BoC cannot lay off the monetary gas pedal (Chart 7A). The BoC has already been aggressive in easing policy earlier this year, cutting the Bank Rate to 0.25%, initiating several liquidity facilities and quickly ramping up bond purchases. The central banks now owns around 40% of all Government of Canada bonds outstanding, from a starting point of essentially 0% before the pandemic, and has started to shift its purchases to longer maturity bonds in order to suppress risk-free yields and lower borrowing costs for households and business. While Canada did see a sharp recovery in GDP growth in Q3 – rising 8.9% on a non-annualized, quarter-on-quarter basis following the -11.3% drop in Q2 – the level of real GDP is still -5.2% lower than Q3 2019 levels.  The BoC has already significantly revised down its estimates of potential growth for 2020-22 by nearly one full percentage point due to the various negative shocks including COVID-19. Inflation remains weak because of significant economic slack – the BoC forecasts that CPI inflation will remain below its target until 2022 (Chart 7B).  Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanada: BoC Monitor BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 7CWeaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Within the details of our BoC Monitor, the weakness in the overall indicator is clearly driven by the depressed level of the growth components (Chart 7C). Heavy containment measures to fight the spread of COVID-19, combined with uneven recoveries in different sectors, have weighed on the Canadian economy. At the same time, the financial conditions components have been relatively stable, even with the rapid expansion of the BoC’s balance sheet. The Canadian dollar has clearly outperformed its typical positive correlation to the BoC Monitor (bottom panel), as the “loonie” has benefitted from rising global commodity prices and the overall depreciation of the US dollar. Both of those trends are likely to remain in place in 2021 as global growth gains upward momentum, which should keep the Canadian dollar well supported – and also force the BoC to stay dovish to prevent an even greater rise in the currency. We currently recommend a neutral stance on Canadian government bonds within global fixed income portfolios. In more normal times, a backdrop of accelerating economic growth and rising commodity prices would typically push Canadian yields higher and justify an underweight stance – particular given the relatively high historical “yield beta” of Canada to changes in US bond yields  (Chart 7D). However, with the BoC forced to stay aggressive with its QE program to dampen Canadian yields and suppress the rising Canadian dollar, Canadian government bonds are likely to outperform their normal high-beta status as US Treasury yields continue to drift higher in 2021. Chart 7DAn Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields RBA Monitor: Not Out Of The Woods Yet Our Reserve Bank of Australia (RBA) monitor remains in “easier policy required” territory despite a strong rebound after bottoming in April (Chart 8A).  Since our last update, the RBA has slashed the official cash rate once more to 0.1%, largely in an effort to contain the surging Australian dollar. The unemployment gap in Australia has staged a tentative recovery but is set to remain elevated and recover only gradually going forward, according to the IMF’s forecast (Chart 8B). The RBA actually sees unemployment ticking up slightly in the near term as the eligibility conditions for the JobSeeker program tighten. Inflation, meanwhile, will have a tough time reaching the target 2-3% band in the absence of wage price pressures. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BA Lot Of Slack In The Australian Economy BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 8CFinancial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Breaking down our RBA monitor into its constituent growth, inflation, and financial conditions components, we see a sharp rebound led by financial conditions which, taken in isolation, are calling for tighter monetary policy (Chart 8C). This comes as no surprise with the RBA growing its balance sheet at an unprecedented rate. The growth component, meanwhile, has been driven by rebounding consumer and business sentiment data with Australia benefitting from Chinese reflation. We are also beginning to see a divergence in the historically tight correlation between the RBA monitor and the trade-weighted Australian dollar, as investors pile into the growth-sensitive currency with the Fed reflating the global economy. For its part, the RBA has tried to combat this by reiterating its support for its QE program and leaving the door open to further bond-buying. We can see the RBA’s core problem summarized in Chart 8D. The rise in Australian bond yields has cornered the RBA towards a more dovish tilt. Although RBA Governor Lowe has ruled out negative rates, the RBA has some bullets remaining, including shifting its purchases to the long-end of the curve. With that in mind, we feel confident reiterating our neutral stance on Australian sovereign debt. Chart 8DAustralian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor RBNZ Monitor: Between A Rock And A Hard Place Our Reserve Bank of New Zealand (RBNZ) monitor has rebounded slightly but is still calling for easing (Chart 9A). While the RBNZ has held its official cash rate steady at 0.25% since our last update, it has expanded its large-scale asset purchase (LSAP) program to a whopping NZD 100bn. Unemployment and output gaps indicate a good deal of slack in the New Zealand economy, with the output gap set to recover slightly faster than the unemployment gap, according to IMF forecasts (Chart 9B). Although inflation momentarily breached the 2% mark, it is expected to remain subdued as spare capacity and low tradables inflation weigh on the overall measure. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Is Set To Subside BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 9CThe Appreciating NZD Is A Problem The Appreciating NZD Is A Problem The Appreciating NZD Is A Problem As with neighboring Australia, financial conditions have led the rebound in the RBNZ monitor while the growth component has ticked up slightly and the inflation component remains subdued (Chart 9C). However, one of the variables in our model, house prices, has recently leapt to the forefront of the monetary policy discussion in New Zealand, with the government asking the RBNZ to cool the rapidly heating market. The RBNZ has responded by reinstating loan-to-value ratio restrictions but we cannot expect the bank to turn hawkish anytime soon, given recent appreciation in the New Zealand dollar, which not only hurts export competitiveness but also threatens import price inflation. Going forward, political pressure on the RBNZ will prevent it from taking an overly accommodative stance and has made it unlikely that the bank will go into negative rate territory next year. The momentum in NZ yields has largely kept pace with our RBNZ monitor despite the dramatic spike last month (Chart 9D). The RBNZ will increasingly have to find ways to suppress both bond yields and the New Zealand dollar without stimulating the housing market. Given these opposing forces, yields will likely move sideways, supporting our neutral stance on NZ sovereign debt. Chart 9DYields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Riksbank Monitor: Sluggish Recovery Ahead Our Riksbank monitor has rebounded but is still calling for easier policy (Chart 10A). Given the bank’s fraught relationship with negative rates and the associated financial stability concerns, it will likely deliver further stimulus in the form of asset purchases, which it has recently ramped up to SEK 700bn while also promising to step up the pace of purchases in the next quarter. Both output and unemployment gaps indicate slack in the Swedish economy, with OECD and IMF estimates pointing towards a gradual recovery (Chart 10B). While GDP in the third quarter did come out stronger than expected, it was likely just a temporary development. After failing to contain surging infections, the Swedish government has finally decided to impose restrictions, which will limit the recovery until we start to see mass immunization. The Riksbank does not expect inflation to be sustainably close to 2% until 2023. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Is Set For A Slow Recovery BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 10CThe Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank Looking at the components of the Riksbank monitor, all of them are currently below zero, implying a need for easier policy (Chart 10C). The growth component rebounded strongly on the back of improving exports and sentiment data. On the currency side, we have seen strong appreciation in the trade-weighted Krona this year, far exceeding the levels implied by our Riksbank monitor. This could dampen export growth in the small, open economy, making it a prime concern for policymakers. While the Riksbank monitor fell drastically, Swedish government bond yields remained largely rangebound this year, with the 10-year yield hovering around zero (Chart 10D). The bottom line is that yields for the most part are reflecting expectations of a policy rate stuck at 0%, that the Riksbank is unwilling to cut and cannot afford to hike. Chart 10DSwedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Norges Bank Monitor: On A Recovery Path Our Norges Bank Monitor is improving from very depressed levels, but still remains well below the zero line. This is signaling that continued monetary accommodation is still needed, but emergency settings are no longer appropriate (Chart 11A). Consistent with the message from the Monitor, Norges Bank governor Øystein Olsen has pledged to keep interest rates at zero for the next couple of years, before a gradual rise begins. The central bank also continues to extend emergency F-loans to commercial banks at 0%, to encourage much needed lending to Norwegian firms. The rebound in Q3 mainland GDP (which excludes oil & gas production) was the strongest on record. The unemployment rate has also declined from a high of 10.4% to 3.9% for the month of November. That said, there was a small tick up in November, a sign that the second wave of COVID-19 engulfing the euro area is beginning to bite into Norwegian growth. Underlying inflation remains above well above target, while headline inflation is slowly rebounding. But given that the output gap is expected to remain wide into 2021, these trends should flatten, rather than accelerate (Chart 11B). Chart 11ANorway: Norges Bank Monitor Norway: Norges Bank Monitor Norway: Norges Bank Monitor Chart 11BNorwegian Inflation Is At Target BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 11CThe Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The key improvement in our Norges Bank Monitor has come from the growth component, which is very close to the zero line (Chart 11C). Not surprisingly, the Monitor shows a very tight correlation with the trade-weighted currency, suggesting the latter is an important valve in adjusting monetary conditions. As an oil-producing economy, the drop in the krone cushioned the crash in oil prices. A recovery will benefit the krone.  The correlation between the Monitor and Norwegian bond yields has become more robust (Chart 11D). This suggest yields in Norway should participate as global yields modestly grind higher. Within a global bond portfolio, our default stance is neutral, as the market is thinly traded. Chart 11DNorwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher SNB Monitor: More Currency Weakness Needed Our Swiss National Bank (SNB) Monitor has shown very tepid improvement, as the SNB has maxed out its policy options (Chart 12A). Interest rates have been at -0.75% since 2015, making the currency channel the only valve to ease monetary conditions. To achieve this, the central has been heavily expanding its balance sheet via the accumulation of foreign assets and reserves. Switzerland has seen a less powerful rebound in Q3 GDP at 7.2%, compared to the euro zone where growth stood at 12.5%. Meanwhile, Q4 data is likely to disappoint as Switzerland was hit harder by the second COVID-19 wave. Labor market tightness has eased, with the unemployment rate at a 2020 high of 3.4%. This will continue to suppress inflationary pressures, which are now the weakest since the 2008 Global Financial Crisis (Chart 12B). Chart 12ASwitzerland: SNB Monitor Switzerland: SNB Monitor Switzerland: SNB Monitor Chart 12BThe Swiss Economy Is Deflating BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 12CThe Swiss Franc Is Too Strong The Swiss Franc Is Too Strong The Swiss Franc Is Too Strong Looking at the components of our SNB Monitor, both growth and inflation are anchoring down the indicator. The message is that Switzerland needs a weaker currency, especially relative to its trading partners (Chart 12C). This concern is repeatedly echoed by SNB governor Thomas Jordan. As such, the Swiss franc should lag other European currencies, including the euro and Swedish krona.  The SNB Monitor does a good job at capturing shifts in Swiss bond yields. Constrained by the lower bound, they were not really able to fall when the pandemic was raging in March. By the same token, they should lag any modest increase in global bond yields, as suggested by the Monitor (Chart 12D). Like Norway, our default stance on Swiss bonds is neutral in a global portfolio, given low market liquidity. Chart 12DSwiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing   Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Shakti Sharma Research Associate shaktiS@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com

Highlights U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Feature Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart II-1 Chart II- Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart II- Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? Chart II-1 To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities Chart II-2 The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-2 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-2 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-2 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset Classes Global Equity Sectors Chart II-3 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart II-3 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart II-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Chart II-4 Chart II-4   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation Footnotes 1       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 2       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 3       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 4       Excess returns are defined as asset return relative to a 3-month Treasury bill. 5       Sector classification does not take into account GICS changes prior to December 2018.  6       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 7       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 8       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.

Highlights The view that the world will sink into a deflationary “ice age” hinges on the assumption that policymakers will make a colossal mistake by failing to do what is in their own best interest. Contrary to popular belief, governments always have a tool to increase inflation, even when an economy has fallen into a liquidity trap: It’s called sustained fiscal stimulus. Japan could have avoided its deflationary epoch if the authorities had eased fiscal policy more aggressively. Ironically, bigger budget deficits probably would have caused the government debt-to-GDP ratio to rise less than it did. The U.S. and China are unlikely to repeat Japan’s mistake. Actually, looking ahead, Japan may not repeat Japan’s mistake. The euro area is a tougher call given the region’s political and institutional constraints; but even there, a reflationary outcome is more likely than not. An intensification of the trade war will cause government bond yields to fall a bit further in the near term. However, yields are likely to be higher one year from now. Global equities will follow the same path as bond yields: Down in the near term, but up over a 12-month horizon. Feature I feel more confident than ever that the next phase of the Ice Age will soon be upon us. Much of the thesis has come from learning the hard deflationary lessons from Japan. Most commenters now accept the Japanification of mainland Europe has occurred, but they just cannot conceive that the same thing might happen with the US. My biggest conviction call is that US 10y bond yields will converge with Japanese and German yields in the next recession at around minus 1% (and US 30y yields will fall to zero or below) and that markets will panic as outright deflation takes an icy grip. -  Albert Edwards, Société Générale (May 2019) Fire Or Ice? If you were to ask most central bankers today whether it is better to err on the side of too much or too little inflation, chances are they would say the former. Their rationale would surely be as follows: If inflation rises to uncomfortably high levels, they can simply raise interest rates in order to cool the economy. In contrast, if inflation gets too low, and interest rates are already close to zero, monetary policy loses potency. It is better to have more control over the economy than less. This reasoning is correct on its own terms, but if one stands back and thinks about it, it is rather perverse to argue that deflation, which generally stems from a lack of aggregate demand, should be more difficult to overcome than inflation, which is usually the result of too much demand. After all, people like to spend money. Getting someone to work and produce should, in principle, be more difficult than getting them to consume. Inflation should be a bigger problem than deflation. So why do so many economists think otherwise? The Paradox Of Thrift There actually is a very good reason for this bias, one which John Maynard Keynes articulated more than 80 years ago. Keynes observed that when unemployment is rising, people are likely to try to save more due to fear of losing their jobs. Since one person’s spending is another’s income, this could create a vicious cycle where falling spending leads to lower aggregate income, and so on. Unfortunately, it is hard to save if you do not have a job. Thus, the decision by all individuals to save more could result, ironically, in a decline in aggregate savings.1 Keynes called this the paradox of thrift. At the heart of the paradox of thrift lies a deep-seated coordination problem. During an economic downturn, everyone would be better off if everyone else spent more money. However, since the spending of any one person only has a negligible effect on aggregate demand, no one has an incentive to spend more than is absolutely necessary. Keynes’ seminal insight was that a government could overcome this coordination problem by acting as a spender of last resort. Keynes argued that if the private sector decides to save more, the public sector should save less by running a bigger budget deficit. The result would be the preservation of full employment. Debt And Deliverance A common objection to the idea that governments should run bigger budget deficits to compensate for inadequate private-sector demand is that this will cause public-sector debt levels to swell to the point that a fiscal crisis becomes inevitable. The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. For countries such as Italy, this is a legitimate concern. If a country does not have a central bank that can serve as a buyer of last resort of government debt, it can end up facing a pernicious feedback loop where rising bond yields increase the likelihood of default, leading to even higher bond yields. These countries can, and often do, face speculative attacks on their bond markets (Chart 1). Chart 1 For countries that issue debt in their own currencies, this concern does not exist. This is because their governments can print money to pay for goods and services. Since the cost to the government of printing a $100 bill is negligible, the government can always conjure up demand out of thin air. Of course, there is a risk that the government will manufacture too much demand and inflation will rise. But if the goal is to prevent deflation, this is a feature not a bug. Once demand increases enough, the government can just pull the plug on further fiscal stimulus, and everyone can live happily ever after. Japan’s Experience Chart 2The 1990s Japanese Example The 1990s Japanese Example The 1990s Japanese Example Didn’t Japan try this approach and fail? No. Japan suffered the mother of all financial shocks in the early 1990s when the real estate and stock market bubbles simultaneously burst. This happened just as the working-age population was peaking, which made businesses even less eager to expand domestic capacity. The result of all this was a massive increase in excess private-sector savings. The government did loosen fiscal policy, but not by enough. Consequently, deflation eventually set in. As inflation expectations fell, real rates rose (Chart 2). Rising real rates put upward pressure on the yen and increased the government’s real debt financing costs. To make matters worse, falling prices made it more difficult for private-sector borrowers to pay back their loans. This further depressed spending. Ironically, had the Japanese government eased fiscal policy more aggressively to begin with, it probably would have been able to trim deficits later on. Nominal GDP would have also increased more briskly. As a consequence, the government debt-to-GDP ratio would have ended up rising less than it did. Today, Japan remains mired in a deflationary mindset. Twenty-year CPI swaps, a proxy for long-term inflation expectations, are trading at 0.3%, nowhere close to the Bank of Japan’s 2% target. Interest rates are stuck near zero, reflecting the fact that the economy continues to suffer from excess savings. Japan Needs Fiscal Stimulus, Not Austerity The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. Given Japan’s pathetically low fertility rate, a sensible strategy would be to offer subsidized housing and baby bonuses to any couple that has three or more children. It is impossible to know how big a budget deficit will be required to reset inflation expectations to a higher level. If people believe that the government is serious about easing fiscal policy by enough to get inflation up to target, real rates will collapse, the yen will fall, and private demand will rise. In the end, the government may not need to raise the budget deficit that much. Even if the Japanese government did have to increase the budget deficit substantially, this would not endanger the economy. As long as the interest rate at which the government borrows is below the growth rate of the economy, any budget deficit, no matter how large, will produce a stable debt-to-GDP ratio in the long run (Chart 3).2 Since there would be no need to ease fiscal policy by so much that the Bank of Japan is forced to lift interest rates above the economy’s growth rate, there is little risk that the debt-to-GDP ratio will end up on an unsustainable trajectory. Chart 3 Chart 4Japanese Excess Savings Are Starting To Recede Japanese Excess Savings Are Starting To Recede Japanese Excess Savings Are Starting To Recede Will the Japanese government heed this advice? While Q1 GDP growth surprised on the upside, this was mainly because of a strong contribution from net exports and inventories. Final domestic demand remains underwhelming. Stronger global growth will help Japan later this year, but we think there is still a 50/50 chance the planned VAT hike will be postponed. Looking ahead, the exodus of Japanese workers from the labor market into retirement will reduce private-sector savings. The household savings rate has already fallen from nearly 20% in the early 1980s to around 4% in recent years. The ratio of job openings-to-applicants has risen to a 45-year high (Chart 4). Falling private-sector savings will raise the neutral rate of interest, thus giving the BoJ more traction over monetary policy. Japan’s deflationary ice age may be coming to an end. Stimulus With Chinese Characteristics Like Japan, China has struggled to consume enough of what it produces. In the days when China had a massive current account surplus, it could export that excess savings abroad. It cannot do that anymore, so the government has consciously chosen to spur fixed-investment spending in order to prop up employment. Since a lot of investment is financed through credit, debt levels have risen (Chart 5). Much of China’s debt-financed investment spending has been undertaken by local governments and state-owned enterprises. This has made credit and fiscal policy virtually indistinguishable. While the general government fiscal deficit stands at a moderate 4.1% of GDP, the augmented deficit, which includes a variety of off-balance sheet expenditures, has swollen to 10.7% of GDP, up more than six percentage points since 2010 (Chart 6). Chart 5China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt Chart 6 As we discussed a few weeks ago in a report entitled “Chinese Debt: A Contrarian View”, there is little preventing the Chinese government from further ramping up credit/fiscal stimulus.3 The fact that the trade negotiations are on the ropes only strengthens the case for additional easing. The government knows full well that it will gain negotiating leverage over the U.S. if the Chinese economy is humming along despite higher tariffs on Chinese imports. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Europe: Turning Japanese? Judging from the fact that German bund yields have fallen to Japanese levels, one might conclude that the Japanification of Europe is complete. There is, however, at least one key macro difference between the two regions: While long-term inflation expectations in the euro area have declined, they are still well above Japanese levels (Chart 7). As a result, real yields are quite a bit lower in core Europe, which gives countries such as Germany and France some cushion of support. Chart 7Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower In Germany Than Japan Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower in Germany Than Japan Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower in Germany Than Japan Chart 8Italian Bond Yields Are Still Worryingly High Italian Bond Yields Are Still Worryingly High Italian Bond Yields Are Still Worryingly High Bond yields remain elevated in Italy, though still below the levels seen last October, and far below their peak during the euro crisis in 2011 (Chart 8). Short of the creation of a pan-euro area fiscal union, Italy’s best hope is that Germany takes steps to reflate its own economy. The conventional wisdom is that the German psyche, ever focused on fiscal discipline, would never permit that to happen. This view, however, forgets that Germany had no trouble violating the Maastricht Treaty’s deficit cap of 3% of GDP in the early 2000s. Germany today sees little need to significantly loosen fiscal policy because years of wage repression, and more recently, a weak euro, have caused its current account surplus to swell to 9% of GDP. However, the country’s ability to push out its excess production to the rest of the world may become more limited in the future. The gap in unit labor costs between Germany and other euro area members has narrowed steadily in recent years. This development has coincided with a decline in Germany’s trade surplus with the rest of the euro area (Chart 9). If the common currency starts to appreciate and wage growth in Germany continues to outpace the rest of the region, the German government may have no choice but to loosen the fiscal screws. Chart 9Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Chart 10U.S.: Federal Discretionary Spending Has Been Gaining Steam U.S.: Federal Discretionary Spending Has Been Gaining Steam U.S.: Federal Discretionary Spending Has Been Gaining Steam   U.S.: Ice Age Vs. Green New Deal While Trump’s tax cuts have gotten a lot of attention, an equally important development in recent years has been the rapid acceleration in federal government spending. From a contraction of 7% in 2013, real discretionary outlays are set to grow by 3% in 2019 (Chart 10). There is little reason to think that the U.S. budget deficit will shrink anytime soon. Taxes may go back up if the Democrats take control of the White House and sweep Congress next year. However, even in that scenario, any increase in tax rates is likely to be neutralized by higher social welfare spending – yes, including partial implementation of the green new deal. Meanwhile, government outlays on Social Security and health care programs such as Medicaid are on track to rise by 5.4% of GDP over the next thirty years (Chart 11). Chart 11 So far, an overstimulated U.S. economy has not produced much in the way of inflation. But with the unemployment rate down to a 49-year low, that could change over the next few years. Recent communications from FOMC members suggest a growing tolerance for a modest inflation overshoot of the 2% target. An outright increase in the Fed’s inflation target is unlikely in the near term, but could become a viable option if realized inflation moves above the Fed’s current comfort zone of 2%-to-2.5% for long enough. If that were to happen, raising the inflation target could turn out to be politically more expedient than engineering a deep recession in an effort to bring inflation back down. It will also help alleviate the rising real debt burden that will ensue from high deficits. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. The Fed is already facing political pressure from the Trump administration to keep rates low. Politics in the U.S. and in many other countries is moving in a more populist direction. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Historically, there is a clear inverse correlation between central bank independence and inflation (Chart 12). Chart 12 Investment Conclusions On the question of whether we are heading for a deflationary ice age or a period of inflationary global warming, we would put higher odds on the latter. Many of the structural factors that have produced lower inflation over the last few decades are in retreat. Globalization has stalled, and may even reverse course if the trade war intensifies (Chart 13). The ratio of workers-to-consumers globally is starting to shrink as the post-war generation leaves the labor force (Chart 14). Central bank autonomy is under attack, while fiscal policy is turning more expansionary. Chart 13The Age Of Globalization Is Over The Age of Globalization Is Over The Age of Globalization Is Over Chart 14The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally To believe that politicians will not dial up fiscal stimulus in the face of a chronic shortfall of aggregate demand is to believe that they will act incompetently. Not incompetent in the low-IQ sort of way. Incompetent in the sense that they will act against their own self-interest. Voters want more employment. In the age of populism, it seems unlikely that politicians with ready access to the printing press will fail to deliver what the people want. We declared “The End Of The 35-Year Bond Bull Market” on July 5, 2016. As luck would have it, this was the very same day that the U.S. 10-year Treasury yield hit an all-time low of 1.37%. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. Right now, we are witnessing a countertrend rally in bond prices. Yields could fall a bit further in the coming weeks if the trade war heats up. However, yields will be higher in 12 months’ time, provided that China and the U.S. begrudgingly reach a trade truce and global growth reaccelerates, as we expect. Global equities are likely to follow the same pattern as bond yields. Trade tensions could push stocks down about 5% from current levels (we are presently positioned for this by being tactically short the S&P 500 against an underlying structural overweight position). However, equities will move to fresh highs over a 12-month horizon as global growth picks up. The recent stock market correction caused our long European bank trade to be stopped out for a loss of 7%. We will re-enter the trade once we conclude that global equities have found a bottom. The dollar will probably strengthen a bit more in the near term, but as a countercyclical currency, the greenback will weaken in the second half of this year. This will provide a good opportunity to go overweight EM and European stocks in common-currency terms.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Another way to see this point is to recall that business spending normally declines when the economy weakens. Investment spending tends to move in lockstep with national savings (indeed, at the global level, the two must be exactly equal to each other). Thus, if consumer spending falls in response to the decision by households to try to save more, and this leads to lower investment, it will also lead to lower aggregate savings. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 3      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 15 Tactical Trades Strategic Recommendations Closed Trades