Japan

Listen to a short summary of this report.     Executive Summary The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The US dollar has bounced off its 50-day moving average. In the recent past, that had led to a period of cyclical strength. The yen rally can be explained by the decline in Treasury yields and the fall in energy prices. Where next for the yen will depend on the time horizon. For investors trying to time the bottom, the euro is not yet a buy, but the common currency is incredibly cheap. Much depends on global/Chinese growth (Feature Chart). One of the key drivers of the dollar is volatility, and the correlation with the MOVE index. Less uncertainty will ease safe-haven demand. Stay short EUR/JPY and CHF/JPY. Remain long EUR/GBP. Maintain a limit sell on CHF/SEK at 10.76. RECOMMENDATIONS inception date RETURN Short EUR/JPY 2022-07-21 3.68 Bottom Line: We are tactically neutral the dollar but will be sellers on strength. Questions And Answers Chart 1Currencies And Yield Differentials Currencies And Yield Differentials Currencies And Yield Differentials It is rare that we receive clients in our Montreal office. This has obviously been doubly the case due to the pandemic and the general hassle of travel nowadays. But when we do, it is a delight. In this week’s report, we got asked a few difficult questions on a tea date. The most important was not surprisingly the dollar view, but also our highest conviction trades in FX markets. We enjoyed the conversation and the intellectual debate, so we thought we would share this with our clients. Hopefully, this answers some of the most pressing questions. We have sliced this into as brief and concise a conversation as we could. Question: It is hard not to notice the steep decline in the dollar over the last few weeks. Should we fade this decline or lean into it? That is a tough question, but our educated guess is to fade it for now. That said, longer-term asset allocators should really be looking at buying extremely cheap G10 currencies on any declines. The drivers of dollar downside have been clear. First, long-term interest rates in the US have fallen substantially. The US 10-year Treasury yield has fallen from 3.5% to 2.7%. In real terms, they have also declined. The 10-year TIPS yield has fallen from 0.85% to 0.23%. On a relative basis, the market is also pricing in that the Fed will cut interest rates next year much faster than other central banks. More simply put, 2-year real bond yields in the US are rolling over, relative to the euro area and Japan, the biggest components of the DXY index (Chart 1). Related Report  Foreign Exchange StrategyHow Deep A Recession Is The Dollar Pricing In? Specific to Japan and the euro area, there has also been another critical factor – the decline in energy import costs. Germany’s trade balance improved markedly in June (Chart 2). This has been the first genuine improvement in a year. There is also discussion to extend the life of existing nuclear power plants, which will help assuage energy import costs. In Japan, trade balance data comes out on Monday next week, so we will see what it reveals. But what has been clear is a political drive to restart nuclear power and wean the Japanese economy off its dependence on oil and gas (Chart 3). Japanese prime minister Fumio Kishida has been very vocal about this in recent speeches. Chart 2Euro Area And Japanese Trade Balances Are Improving Euro Area And Japanese Trade Balances Are Improving Euro Area And Japanese Trade Balances Are Improving Chart 3A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? A Nuclear Renaissance In Japan? Turning to the more important part of your question, should we fade the decline or lean into it? We are of two minds on this to be honest, and here is why. The DXY has bounced off its 50-day moving average, which has been a sign in the past that the rally is not over (Chart 4). Our Geopolitical and Commodity & Energy colleagues are telling us not to trust the decline in oil prices. Our bond strategists think US yields are heading higher, with a whisper floor of 2.5%. Chart 4The DXY Has Support At The 50-Day Moving Average The DXY Has Support At The 50-Day Moving Average The DXY Has Support At The 50-Day Moving Average Given these crosscurrents, there are many better opportunities that exist in FX at the crosses, rather than playing the dollar outright. But of course, the dollar call is critical. We would be neutral over the next three-to-six months but be incremental sellers of the dollar on strength. Question: Okay, neutral dollar for now, but bearish long term. We tend to consider longer-term investments as well, and we are confused about the euro, but even more so about the yen. Would you buy the yen today? If so, why? Our starting point for many currencies is valuation. On this basis, the yen is incredibly cheap. So, if you have a five-to-ten-year horizon, you can unlock incredible value in Japan, simply on a buy-and-hold basis. Our in-house curated model shows that the yen is at a multi-general low in value terms (Chart 5). Currencies mean-revert. Consider this for a minute – we are not equity experts, but Toyota trades at a P/E of 10.75, while Tesla trades at a P/E of 109.15. And yes, Toyota has electric cars. Chart 5The Japense Yen Is Incredibly Cheap The Japense Yen Is Incredibly Cheap The Japense Yen Is Incredibly Cheap Chart 6The Yen Is A Favorite Short The Yen Is A Favorite Short The Yen Is A Favorite Short It is true that a winner-takes-all mantra can be attributed to Tesla’s valuation over Toyota, but our colleagues in the Global Investment Strategy are telling us this era is over. As such, at a 40% discount, the yen is a long-term buy in our books. Interestingly, nobody likes the yen, at least by our preferred measure – net speculative positions. It is one of the most shorted G10 currencies (Chart 6). A cheap currency that is the most shorted ranks quite well in our evaluation of bargains in currency markets. Given my discussion above about the dollar, we have played the yen at the crosses. We are short EUR/JPY and CHF/JPY. On the euro, Japanese car manufacturers are simply becoming more competitive than their eurozone or US counterparts. This is not only related to the car industry, but according to the OECD, EUR/JPY is expensive on a purchasing power parity basis (Chart 7). Meanwhile, a short EUR/JPY trade is a perfect hedge for a pro-cyclical portfolio. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate (Chart 8). This suggests the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that the yen should trade higher vis-à-vis the euro. Chart 7Remain Short ##br##EUR/JPY Remain Short EUR/JPY Remain Short EUR/JPY Chart 8The DXY And EUR/JPY Usually Track Each Other The DXY And EUR/JPY Track Each Other EUR/JPY And The DXY: Unsustainable Gap The DXY And EUR/JPY Track Each Other EUR/JPY And The DXY: Unsustainable Gap Question: Okay, let’s switch to the euro. I know you are short EUR/JPY, which has been working out well in the last few days. But the euro touched parity and I get a sense that it has bottomed. You have often mentioned that the euro has priced in one of the deepest recessions in the eurozone. I am surprised you are not trumpeting this currency and a once-in-a-lifetime buying opportunity. We agree somewhat with your conclusion but not the premise. Let’s consider the narrative over the last few months in the media. The first was that eurozone inflation will never catch up to the US, because the economy was structurally weak. Well, it did, albeit due to an exogenous shock.  So, among a ranking of stagflationary candidates, the euro area is a top contender. If you believe in the idea that currencies are driven by real interest rates, rising inflation, and falling growth are an anathema for the exchange rate. When we typically have doubts about the euro area economy, and the outlook for its financial markets, we consult with our European Investment Strategy colleagues. We did just that and Mathieu Savary, who heads the service, mentioned two things: one – Chinese import volumes are imploding. For net creditor nations, this is a negative as their source of income is waning. The euro area falls into that category. The second thing to consider is that the dollar is a momentum currency. So is the euro. We mentioned earlier that the dollar bounced off its 50-day moving average, which explains euro weakness in recent trading days. In the end, Mathieu and the FX team did not really disagree, but I highlighted two charts to track. The euro tracks the Chinese credit impulse due to the importance of Chinese import demand for the euro area. It looks like our measure of that impulse has bottomed (Chart 9). If it has, you buy the euro on a long-term view. Relatedly, financial conditions are easing in China. As the Chinese bond market becomes more open and liberalized, bond yields become a financial conditions valve. That has been the case and has perfectly tracked the propensity for imports in the last few years (Chart 10). Chart 9The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse The Euro And The Chinese Credit Impulse Chart 10Financial Conditions Are Easing In China Financial Conditions Are Easing In China Financial Conditions Are Easing In China In short, we will buy the euro if it touches parity, and even more so below parity with a 5–10-year view, but we think EUR/USD could touch 0.95 in the near term. I guess what we are saying is that a 5%-7% move is big in FX markets, but a 26% move (the undervaluation of the euro) is a whale. We do not see the catalyst for a whale in our current compass. Question: We have talked about the yen and the euro. I do not want to get into the pound, Australian dollar, and other currencies as you have told me your team has upcoming reports on those. But the Chinese yuan is very important in my investment portfolio. Any ideas on its next move? USD/CNY topped out near 6.8 in May. Since then, it has been in a trading range despite the DXY breaking to multi-decade highs (Chart 11). When a pattern like this emerges, it is always useful to revisit fundamentals. Those fundamentals are real interest rate differentials. We care about the yuan because China is a big trading partner of the US. As such, it is also a huge weight in the broad trade-weighted dollar index. China has huge problems, especially related to the property market, which need to be resolved. Bond yields have also collapsed. But the real interest rate in China is very attractive (Chart 12). It is also important to consider that if the dollar is the global safe haven, that means that the yuan could be becoming the haven in Asia. So, yuan downside is not a big risk for our long-term dollar bearish call. That said, we will be short CNY versus the yen, but not the dollar. Chart 11The RMB Has Been Relatively Resilient The RMB Has Been Relatively Resilient The RMB Has Been Relatively Resilient Chart 12The RMB Has Undershot Real Rate Differentials The RMB Has Undershot Real Rate Differentials The RMB Has Undershot Real Rate Differentials Question: I think I could sit with you all morning to discuss other aspects of FX,  but I respect you have a tight stop due to the BLU meeting. Any concluding thoughts? I have one. Very often, we debate with our colleagues about capital flows. The dollar rises (in general), as capital inflows accelerate into the US and vice versa. It is often said that getting the dollar call right gets everything else right. So, if you can predict the path of the dollar, the performance of, say, US versus non-US equities becomes easy. Chart 13The Dollar And Earnings Revisions The Dollar And Earnings Revisions The Dollar And Earnings Revisions We agree that the dollar is a real-time indicator of relative fundamentals. But here is one important observation: relative earnings revisions are deteriorating in the US vis-à-vis other countries (Chart 13). That has historically had an impact on exchange rates, as it affects equity capital flows. If the Federal Reserve also cut rates next year as the market is predicting, that will also be a negative for bond inflows. We think the global economy will avoid a deep recession, and that will allow growth to pick up outside the US. When the euro area and China bottom, then the dollar will truly peak, as capital flows to these economies will accelerate. So we are watching relative earnings and bond yield differentials closely.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report.     Executive Summary US Lead On Mega-Sized Firms: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? The US has been the star protagonist of global equity markets for decades. It offers investors the rare combination of a big economy and a large universe of mega-sized listed companies. In fact, the overwhelming majority of the top 20 largest firms globally by revenue today are American. But can the US maintain this degree of presence on this list over the next decade? We think that this is unlikely. For starters, a decline in the US’s footprint could be driven by the fact that there is a peculiar stagnation in the works in the middle tier of American firms. Given that this tier acts as a talent pool for big firms, a stagnation here could mean that the US spawns fewer super-sized firms. The high market share commanded by big American firms could also end up being a liability. This dominance could bait regulatory attention, thereby affecting these firms’ growth prospects. Finally, slowing GDP growth in the US, as compared to its Asian peers, will prove to be another headwind that American firms must contend with. What should strategic investors do to prepare for this tectonic shift? We recommend reducing allocations to US equities over the long run since the US’s weight in global indices will peak soon (or may have already peaked). Bottom Line: Irrespective of what the Fed does (or does not do), the US’s footprint in the global league tables of big firms by revenue will weaken over the next decade. Strategic investors can profit from this change by reducing allocations to US equities while increasing allocations to China as well as a basket of countries including Korea, Japan, Taiwan, and Germany.   Dear Client, This week, we are sending you a Special Report by Ritika Mankar, CFA, who will be writing occasional special reports for the Global Investment Strategy service on a variety of topical issues. Ritika makes the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. We will return to our regular publishing schedule next week. Best Regards, Peter Berezin, Chief Global Strategist US: Home To The Largest Number Of Big Listed Firms 2022 has been a turbulent year for US markets so far. But it is worth bearing in mind that the US has been the star protagonist of global equity markets for decades. This is because the US has offered investors a near-perfect trifecta constituting of: (1) A mega-sized economy; (2) A large universe of mega-sized listed companies; and (3) A track record of market outperformance. Specifically: Largest Economy: For over a century now, the US has been the largest economy in the world – a title it is expected to defend over the next few years (Chart 1). Large Listed Companies: The US’s high nominal GDP has also translated into high sales growth for its listed space. This, in turn, powered a great rise in the American equity market’s capitalization (Chart 2). In fact, the US’s market cap is so large today that it exceeds the cumulative market cap of the next four largest economies in the world, by a wide margin. So unlike Germany or China (which have large economies but small markets), the US has a large economy and is also home to some of the largest, most liquid stocks globally. Chart 1The US Will Remain The World’s Largest Economy For The Next Few Years America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 2The Listed Universe In The US Has Grown From Strength To Strength America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 3Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Long History of Outperformance: And most importantly, the US market has a strong track record of outperformance. US markets have outperformed global benchmarks over the past decade thanks largely to the rapid sales growth seen by American firms (Chart 3). Notwithstanding the US’s star role in global markets thus far, in this report we highlight that the US’s heft will likely decline over the next decade. The Fed may or may not administer recession-inducing rate hikes in 2022. But irrespective of what the Fed does over the next 12-to-24 months, the US’s loss of influence in global equity markets appears certain because it will be driven by structural forces. Chart 4US Lead On Mega-Sized Firms: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Firstly, while behemoths such as Apple and Amazon have been attracting record investor attention, it is worth noting that the next tier of mid-sized American companies is no longer thriving as it used to. The reason why this matters is because history suggests that the pool of mid-sized companies acts as a superset for the big companies of tomorrow. So, if this talent pool is not booming today in the US, then there is likely to be repercussions tomorrow. Secondly, the US’s largest firms will have to contend with two structural headwinds over the next decade, namely increased regulatory attention and slowing growth. To complicate matters for American firms, competitors in Asia will not have this albatross around their neck. Hence, the US may remain the largest economy of the world a few years from now but is unlikely to be home to as many big, listed companies as it is today (Chart 4). The rest of this report quantifies the strength of these forces, and then concludes with actionable investment ideas.   Trouble In The Talent Pool Chart 5The US Is Home To Nearly A Dozen Mega-Sized Firms Today America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 2021 produced a special milestone for the American economy. This was the first year that ten listed American firms1 surpassed $200 billion in annual revenues (firms we refer to as ‘Big Shots’ from here on) (Chart 5). The US has been a global leader when it came to the size of its economy for decades, but last year it also became home to the largest number of big, listed corporations (Table 1). American Big Shots were striking both in terms of their number as well as their scale. In fact, such was their scale that the combined revenue of these ten Big Shots now exceeded the nominal GDP of major economies like India (Chart 6). Table 1The US Today Dominates The Global List Of Top 20 Firms America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 6The Revenues Of US Big Shot Firms Are Comparable To India’s Nominal GDP! America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? While the world has been captivated by the size that the US’s Big Shots have achieved (as well as the ideas of their unconventional founders), few have noticed that the talent pool for tomorrow’s Big Shots is no longer burgeoning. History suggests that most Big Shot firms tend to emerge from firms belonging to a lower revenue tier.  For instance, Amazon and Apple, which have revenues in the range of $350-to-$500 billion today, were mid-sized firms a decade ago with revenues in the vicinity of $50-to-$100 billion (Chart 7). Chart 7Most Big Shots Today Were The Mid-Sized Firms Of Yesterday America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? This is why it is worrying that all is not well in the US’s ecosystem of mid-sized firms. If we define firms with annual revenues of $50-to-$200 billion as ‘core’ firms, then their share in the total number of American firms has stagnated over the past decade (Chart 8). Even the revenue share accounted for by core firms has been fading (Chart 9). This phenomenon contrasts with the situation in China, where the mid-sized firms’ cohort has been growing over the last decade (Charts 10 and 11). Chart 8Share Of Mid-Sized Firms In The US Has Stagnated America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 9The Revenue Share Of US Mid-Sized Firms Is Also Falling America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 10Share Of Mid-Sized Firms In China Is Expanding America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 11The Revenue Share Of Chinese Mid-Sized Firms Is Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Japan’s experience also suggests that when the mid-sized firms’ ecosystem weakens, the pipeline of future potential mega-cap companies get affected. In Japan, the proportion of core firms (Chart 12), as well as their revenue share (Chart 13), has not been growing as is the case, say, in China. And this is perhaps why, despite being the third-largest economy in the world today, Japan is home to only one listed mega-sized corporation with revenues of over $200 billion (Toyota). Image Chart 13The Revenue Share Of Japanese Mid-Sized Firms Has Plateaued America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? The US May Have Hit Peak Oligopolization The fact that ten Big Shot firms (i.e., firms with annual revenues of over $200 billion) exist in the US today is remarkable. After all, the number of Big Shot firms in the US today exceeds the total number of Big Shots in the next four largest economies of the world combined (Chart 14). Chart 14The US Today Is The Global Hub For Mega-Sized Companies America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? So why will the US’s leadership in this area come under pressure going forward? One reason is that the large size of American firms could itself become a liability. Specifically: Public Backlash Against The US’s Big Shots: The ten Big Shot firms of the US today account for more than a fifth of the revenue generated by all firms that constitute the MSCI US index (Chart 15). Also, the number of Big Shot firms, as a share of total firms, is high in the US (Chart 16). Chart 15Big Shots Account For More Than A Fifth Of Revenues Generated By The US Listed Space America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 16A Large Proportion Of Firms In The US Are Very Big America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Notably, market leaders across a range of key sectors in the US account for an unusually large chunk of the sector’s revenues. Financials, Information Technology, and Consumer Discretionary together account for about half of the US equity market index’s weight. The dominant firm in each of these three sectors (as defined by MSCI) accounts for 15%-to-25% of that sector’s revenue (Chart 17). Market power usually benefits investors. But too much market power can be a problem. The growing oligopolization of the US economy has caused public dissatisfaction over the influence of corporations in the US to hit a multi-year high (Chart 18). Over 60% of Americans want major US corporations to have less influence. It is for this reason that the record scale acquired by American firms could prove to be an issue. American mega-scaled firms’ high market shares will provide them with pricing power, but this very power will end up baiting regulatory attention and anti-trust lawsuits which, in turn, will restrict their future growth rates. The fact that the US Federal Trade Commission (FTC) today is headed by a leader who wants to return the FTC to its trust-busting origins, and made her name by writing a paper arguing for Amazon to be broken up,2 is indicative of which way the wind is blowing. Chart 17Market Leaders In The US Are Too Big America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 18Public Dissatisfaction With US Big Shot Firms Is High And Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Interestingly, the speed at which the US restricts the market power of big firms will determine how quickly the US’s mid-sized firms begin to flourish again, thereby setting the stage for the US to spawn a new generation of big firms. Besides the growing regulatory risks for the US’s big firms, three other technical factors will end up slowing the pace at which the US can generate large firms, namely: Slowing GDP Growth: Since the US is a large and mature economy, the pace of its growth is bound to slow (Chart 19). Besides the deceleration in the US’s growth rate relative to its own past, it is projected to end up being lower than that of major economies like China. Chart 19US GDP Growth Is Set To Slow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Big Business ≠ Big GDP Growth: While GDP growth receives a fillip when small firms grow, the high pricing power that very large firms command can end up constraining an economy’s growth rate. This is because large firms can charge monopolistic prices, thereby restraining demand. Secondly, mega-sized firms may actively invest in manipulating institutions to block upstarts,3 a dynamic that can restrict productivity growth as well. Chart 20The Revenue-To-Nominal GDP Ratio Is Already Elevated In The US America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Approaching Revenue Saturation: A cross-country comparison suggests that the revenue-to-nominal GDP ratio in the US is high1 (Chart 20). Only Japan has a superior ratio, which is likely to be an aberration rather than the norm (owing to Japanese firms’ unique tendency to prioritize revenues over profitability). Given that the US revenue-to-nominal GDP ratio is already elevated, it is likely that even as the US’s nominal GDP keeps growing, the pace of conversion of this GDP into revenues will stay the same or may even diminish over the coming decade.   Prepare For A Brave New World “German judges…first read a description of a woman who had been caught shoplifting, then rolled a pair of dice that were loaded so every roll resulted in either a 3 or a 9. As soon as the dice came to a stop, the judges were asked whether they would sentence the woman to a term in prison greater or lesser, in months, than the number showing on the dice…On average, those who had rolled a 9 said they would sentence her to 8 months; those who rolled a 3 said they would sentence her to 5 months; the anchoring effect was 50%.” – Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011)   The US has been the largest economy in the world and has also been able to nurture some of the largest mega-scaled companies of today. Such is the might and size of these firms that it is impossible to imagine a world where American firms’ leadership could be disrupted. Moreover, it is mentally easier to extrapolate the US’s lead today into the future. It may even seem like there is no other alternative to the US since Japan’s economy has been stagnating, Europe lacks innovation, and the political environment in China is contentious. Also, it is true that the US today is the undisputed leader when it comes to qualitative factors such as the ability to attract top global talent, its education system, and its legal system. However, the case can be made that this belief (that the US’s lead on mega-sized companies will spill into the next decade) runs the risk of becoming a Kahneman-esque anchoring bias. This is because: History Suggests That Upsets Are The Norm: History suggests that the evolution of the top 20 global firms (by revenue) has been a story of upsets. For instance, Europe’s hold over this list in the 2000s was striking by all accounts (Chart 21). Back then, it would have been almost blasphemous to question Europe’s lead (Chart 22). But today firms from three Asian island-countries account for more companies on this list than all of pre-Brexit Europe put together. Chart 21In The 2000s, Europe Was The Epicenter Of Global Mega-Sized Firms America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 22How The Mighty Can, And Do, Fall America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​China’s Disadvantages < Its Competitive Advantages: Despite its political baggage, China has the most formidable capability today to displace the US’s leadership position on the league tables of top 20 global firms by revenue. This is because China has a thriving ecosystem of core firms (Chart 11) and is set to grow at a faster clip than the US over the next five years (Chart 19). Moreover, while the Chinese government’s tolerance for large tech giants could remain low, the establishment could be keen to grow firms in the industrials as well as financials space for the sake of common prosperity. EM Listed Space Can Catch Up: The listed space in the US has developed at an exceptionally fast pace relative to its peers. The gap between US nominal GDP and listed space parameters is low (Chart 20), while the gap is wider for countries like Germany, China, and several other EMs. Even in a ceteris paribus situation where nominal GDPs were to stay static, an increase in the size of the listed universe in other countries can adversely affect the US’s current footprint. So, what can investors do to prepare for this coming tectonic shift? We recommend reducing allocations to US equities since the US’s weight in global indices will peak soon. It is worth noting that this strategic investment recommendation dovetails nicely with our earlier view that strategic investors should rotate out of US stocks. Currently, about half of the 20 largest firms globally by revenue are American (Map 1). Owing to the dynamics listed above, the number of American firms in the global league of top 20 could fall from this high level to 7 or 8 over the coming decade. Given that this change is indicative of things to come, we would urge investors to reduce allocations to US equities in a global portfolio over a strategic horizon. A confluence of micro and macro factors is likely to result in the US’s weight in global indices to crest sooner rather than later. Map 1Could The Global Epicenter Of Big Firms Drift Eastwards Over The Next Decade? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? In fact, US equities’ weight in a global index like the MSCI ACWI could have already peaked (Chart 23) and could fall by 500-to-600bps over the next decade if the last year’s trend is extrapolated into the future. As regards to sectors, health care appears to be the key industry where the US’s footprint could weaken (Table 2). Chart 23Loss Of US Influence Will Create Space For Underrepresented Markets To Grow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Table 2China’s Weight In Top 20 Firms Is Set To Grow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? As the US cedes its leadership position, we expect the global epicenter of mega-sized listed corporates to drift eastwards (Map 1). Specifically: China: Currently, less than a quarter of the 20 largest firms globally by revenue are Chinese (Map 1). It is highly likely that the number of Chinese firms in the global list of top 20 firms will increase. China should be able to spawn more mega-sized companies since it already has a cache of promising large and mid-sized companies. Chinese companies will also benefit from the high growth rate of China’s domestic economy. From a sectoral perspective, financials and industrials appear to be two sectors where China’s footprint could grow the most (Table 2). Asia Ex-China: Asian countries like Korea, Taiwan, and Japan could potentially end up growing their weight in global equity indices by becoming home to more than one company that makes it to the global league tables of large companies. Besides the high GDP growth rate on offer in their domestic markets (Chart 20), firms in these countries could increase scale by feeding a stimulus-fueled industrial boom in the US. Additionally, these Asian countries have a competitive advantage when it comes to high-tech manufacturing capabilities (Chart 24). This will ensure that they will accrue any offshore opportunities that arise. Taiwan has the potential to grow its presence in the Information Technology space, given its innate competitive advantages (Chart 24) and the positive structural outlook for global semiconductor demand. In the case of India, it is worth noting that the country’s influence in the world economy will be ascendant over the next decade as its growing middle class flexes its muscles. Despite this, the probability of an Indian firm making an appearance among the largest firms of the world is low given the unusually small size of Indian companies today. Europe: Distinct from the Asian countries listed above, Germany could benefit from the industrial boom in the US given its capabilities when it comes to high-end manufacturing (Chart 24). ​​​​​​​Even as we believe that oil faces a bleak future on a structural basis, if a commodities supercycle were to take hold over the next decade, then the UK and France could improve their presence in global equity benchmarks given that Europe is home to some large firms in the energy sector. A commodities supercycle will also end up benefiting China and the US, since some large energy producers are also located in these countries. Chart 24Korea, Japan, And Germany Have An Edge In Manufacturing, While Taiwan, Japan, And China Have An Edge In Semiconductors America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​Appendix The Methodology The starting point for most country-level economic analyses tends to be a country’s nominal GDP. But as market economists we realized that some key advantages could be unlocked by focusing on ‘revenues’ generated by the listed universe of a country. These advantages include: Investment Focus: As compared to nominal GDP which ends up picking up signals about the health of the listed ‘and’ unlisted firms in any country, focusing on listed firms’ revenues allows us to home-in on the health of the listed space. This is a valuable merit since the listed space is what public equity investors can buy into. For example, India is the fifth largest economy of the world and is also one of the fastest growing economies globally. But India is also characterized by a listed space where the largest companies have revenues of only around $100 billion. This makes India less investable than countries like Taiwan or South Korea that have far smaller nominal GDPs as compared to India but are home to firms with revenue of around $200 billion. Taking note of this difference - between the size of a country’s nominal GDP and the size of investable firms in a country - is key for our clients. Focus On Cause, Not Effect: It is fashionable today in the financial press to focus on the daily changes in market capitalization of assets (and non-assets too). But it is critical to note that the market cap of a stock or the price of a security is a dependent variable. Revenue, on the other hand, is a key independent variable that influences prices. So, a focus on forecasting movement in revenues of companies in a country ten years down the line, can be a more fruitful exercise for strategic investors. Steady And Stable: Revenue generated by a firm, is also a superior measure as compared to the market capitalization of a firm because the latter can be volatile. Whilst it could be argued that earnings of a company as a variable also offer stability and influence prices, earnings suffer from one drawback which is that it is a function of revenues as well as costs. Revenues of companies on the other hand have a direct theoretical link to the nominal GDP of a country. So, to rephrase a popular adage - market cap is vanity, nominal GDP is sanity, but revenue is king. This is the reason why in this Special Report, we analyze investment opportunities through the lens of revenues generated by listed firms in some of the largest economies of the world. We do so by focusing on the constituents of MSCI Country Indices (Equity) for major world economies in 2021. ​​​​​​​ Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Footnotes 1  Based on MSCI ACWI data for 2021. 2  Kiran Stacey, “Washington vs Big Tech: Lina Khan’s battle to transform US antitrust,” ft.com, August 2021. 3  Kathy Fogel, Randall Morck, and Bernard Yeung, “Big Business Stability And Economic Growth: Is What’s Good For General Motors Good For US?”, NBER Working Paper No. 12394, nber.org, July 2006.

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1   Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price.  When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5)  April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal   Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 Chart 1AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1  Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. Fractal Trades Fractal Trading Update - June 2022 Fractal Trading Update - June 2022 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - 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   Indicators To Watch - Interest Rate Expectations 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  

Listen to a short summary of this report.         Executive Summary US Financial Conditions Have Tightened Significantly This Year US Financial Conditions Have Tightened Significantly This Year US Financial Conditions Have Tightened Significantly This Year US financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations. If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the US and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. Stay overweight stocks, favoring non-US equities over their US peers. We are closing our short 10-year Gilts trade, initiated at a yield of 0.85%, for a gain of 7.5%. We are also opening a new trade going long Canadian short-term interest rate futures versus their US counterparts. Investors expect Canadian rates to exceed US rates in 2024, which seems unlikely to us given that the Canadian housing market is much more sensitive to higher rates than the US market. Bottom Line: After having tightened significantly over the past seven months, financial conditions should loosen modestly during the remainder of the year. This should benefit risk assets. Fed Focused on Financial Conditions Chart 1Tighter Financial Conditions Will Hurt Growth Tighter Financial Conditions Will Hurt Growth Tighter Financial Conditions Will Hurt Growth Like many central banks, the Fed sees financial conditions as a key driver of the real economy. While there are many financial conditions indices (FCIs), most include bond yields, credit spreads, equity prices, and the exchange rate as inputs. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa. Goldman’s US FCI is especially popular among market participants. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the historic relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below-trend pace by the second quarter of 2023. In fact, the tightening in the Goldman FCI over the past 12 months already suggests that the manufacturing ISM will fall below 50 (Chart 1).  Along the same lines, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved slightly into restrictive territory. Aside from a brief period at the outset of the pandemic, the index has been consistently in expansionary territory since early 2013 (Chart 2). Chart 2The Chicago Fed Financial Conditions Index Has Moved Into Slightly Restrictive Territory Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? Other data are consistent with the message from the FCIs. Most notably, growth estimates for the US and for other major economies have come down over the past few months (Chart 3). Economic surprise indices have also fallen, especially in the US.   Chart 3AGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Chart 3BGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Mission Accomplished? Chart 4The Fed Expects To Lift Rates Above Its Estimate Of Neutral The Fed Expects To Lift Rates Above Its Estimate Of Neutral The Fed Expects To Lift Rates Above Its Estimate Of Neutral Given the recent tightening in financial conditions and weaker growth expectations, the Fed is likely to soften its tone. Already this week, Atlanta Fed President Raphael Bostic suggested that the Fed could pause raising rates in September in order to assess the impact of the Fed’s tightening campaign. The Fed minutes also conveyed a sense of flexibility and data-dependence about the timing and magnitude of future hikes once rates reach 2%. It’s worth stressing that the Fed expects rates to rise in 2023 to about 40 bps above its estimate of the terminal rate (Chart 4). Jawboning rate expectations higher would potentially undermine the Fed’s goal of achieving a soft landing for the economy. Inflation Will Dictate How Much Easing Lies Ahead There is a big difference between not wanting financial conditions to tighten further and wanting them to loosen. The Fed would only want to see an easing in financial conditions if inflation were to fall faster than expected. Chart 5 shows how the year-over-year change in the core PCE deflator would evolve over the remainder of the year depending on different assumptions about the month-over-month change in the deflator. The Fed would be able to reach its expectation of year-over-year core PCE inflation of 4.1% for end-2022 if the month-over-month change averages 0.33%. Monthly core PCE inflation averaged 0.3% in February and March and is expected to clock in at around the same level for April once the data is released tomorrow. Chart 5AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) Chart 5BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) Regardless of tomorrow’s data print, as we discussed last week, we expect the monthly inflation rate to average less than 0.3 in the back half of the year. If that happens, inflation will surprise to the downside relative to the Fed’s expectations. Consistent with the observation above, market-based inflation expectations have already declined. The 5-year TIPS inflation breakeven has fallen from 3.64% in March to 2.98% at present. The widely watched 5-year/5-year forward breakeven rate is back down to 2.29%, at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 6).1 The Citi US Inflation Surprise Index has also rolled over (Chart 7). Chart 6Market-Based Inflation Expectations Have Come Down Of Late Market-Based Inflation Expectations Have Come Down Of Late Market-Based Inflation Expectations Have Come Down Of Late Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over Financial Conditions  Abroad Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar (Chart 8). Nevertheless, with growth momentum having already deteriorated sharply, central banks are signaling a more balanced approach towards policy normalization. Chart 8Financial Conditions Have Tightened More In The US Than Elsewhere This Year Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? ECB: Wait and See? In a blog post published on Monday, Christine Lagarde observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than they were two years ago. In her mind, this warrants ending net purchases under the Asset Purchase Programme early in the third quarter. It also warrants raising the deposit rate by 25 bps at both the July and September meetings, bringing it back to zero from -0.5% at present. Beyond then, Lagarde was circumspect about what should be done, stressing the need for “gradualism, optionality and flexibility.” She noted that “The euro area is clearly not facing a typical situation of excess aggregate demand or economic overheating … Both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends.” She then added: “The outlook is now being clouded by the negative supply shocks hitting the economy … households’ expectations of their future financial situation dropped to their second-lowest level on record in March and remained close to that level in April.” The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023 (Chart 9). BCA’s Global Fixed Income team, led by Rob Robis, foresees only 50 bps of tightening over the next 12 months. Chart 9Markets Expect Rates To Rise The Most In The Anglo-Saxon World Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? The UK, Canada, and Australia: Frothy Housing Markets Will Limit Rate Hikes The Bank of England (BoE) hiked rates by 90 bps over the past 12 months. The UK OIS curve is priced for another 140 bps of rate hikes over the next year. According to the BoE’s forecasting models, this would raise the unemployment rate by two percentage points while lowering inflation to below 2% within the next two-to-three years. In our opinion, that is more tightening than the BoE would like to see. BCA’s strategists expect the BoE to deliver only another 75 bps of hikes over the next year. Chart 10Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries The Canadian economy has been quite strong, with the unemployment rate falling to 5.2% in April, the lowest since 1974. The Canadian OIS curve is discounting 195 bps of interest rate hikes over the next 12 months, substantially more than the 150 bps of tightening our fixed income team foresees. By mid-2024, investors expect Canadian policy rates to be about 25 bps above US rates. This seems unreasonable to us, and as of this week, we are expressing this view by going long the June 2024 3-month Canadian Bankers’ Acceptance (BAX) futures contract (BAM4) versus the corresponding 3-month US SOFR futures contract (SFRM4). A more liquid option is to simply go long the 10-year Canadian government bond versus the 10-year US Treasury note. At present, Canadian 10-year government bonds are yielding  5 bps more than their US counterparts. Unlike in the US, where household debt has fallen over the past 14 years, debt in Canada has risen, fueled by a massive housing boom (Chart 10). High indebtedness and the prevalence of variable rate/short-term fixed-rate mortgages will limit the ability of the BoC to raise rates. The Australian OIS curve is currently discounting 262 bps of rate hikes over the next year which, if realized, would take the cash rate to 3.3% – a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. BCA’s fixed income strategists expect only 150 bps of tightening over the next 12 months. Japan: Yield Curve Control Will Continue Chart 11Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World The Bank of Japan expects inflation excluding fresh food prices to remain at about 2% in the second half of 2022, but then to slow to 1.1% in the fiscal year starting April 2023. The Japan OIS curve is discounting almost no tightening over the next 12 months. Long-term inflation expectations are far lower in Japan than in any other major economy, which makes ultra-low rates a necessity for the foreseeable future (Chart 11). China: Outright Easing Chart 12Covid Restrictions Have Eased Only Modestly In China Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? China faces a trifecta of problems: A weakening housing market; slowing external demand for manufactured goods; and the ongoing threat of Covid-related lockdowns. Despite a steep drop in the number of new Covid cases over the past month, China’s lockdown index has only eased modestly, as the authorities continue to fret about the next outbreak (Chart 12). The leadership in Beijing has responded with policy easing. The PBoC lowered the 5-year loan prime rate by 15 bps last week, the largest such cut since 2019. This followed a cut in the floor rate for first-home mortgages that was announced on May 15. BCA’s China strategists believe these measures will arrest the deep contraction in the property market but will not spark a full-blown recovery due to the ongoing commitment of the government to the “three red lines” policy.2  In normal times, a Chinese real estate slump would be a cause of grave concern for global investors. These are not normal times, however. Public enemy number one these days is inflation. A weaker Chinese property market would curb commodity demand, thus helping to cool inflation. That would be a welcome development for global investors. Investment Conclusions Global financial conditions have tightened to the point that betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric.  We took partial profits on our short 10-year Treasury trade earlier this month (initiated at a yield of 1.45%). As of this week, consistent with the earlier decision of BCA’s fixed income strategists to upgrade UK Gilts, we are closing our short 10-year Gilt position (initiated at a yield of 0.85%) for a gain of 7.5%. The coming Goldilocks environment of falling inflation and supply-side led growth will buttress equities. We expect global stocks to rise 15%-to-20% over the next 12 months, with non-US markets outperforming the US. Looking further out, the fate of Goldilocks will rest on where the neutral rate of interest resides. If the neutral rate in the US turns out to be substantially lower than 2.5%, then any growth recovery will falter as the lagged effects of restrictive monetary policy work their way through the economy. Conversely, if the neutral rate turns out to be substantially higher than 2.5%, then inflation will reaccelerate as the economy overheats. Given the choice, we would wager on the latter outcome. Thus, while we expect global bond yields to decline over a 12-month horizon, we foresee them rising over a 2-to-5-year time frame. Similarly, while stocks will strengthen over the next 12 months, they are likely to encounter another bout of turbulence starting late next year or in 2024 as central banks initiate a second round of rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter     Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? Special Trade Recommendations Current MacroQuant Model Scores Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough?