Mega Themes

Executive Summary Global inflation will peak sometime in the next few months, a process that has likely already begun in the US. This will give policymakers some breathing room to turn less hawkish, a more credible stance given softening global growth momentum and increased financial market volatility. Our Global Golden Rule of Bond Investing suggests that overall government bond returns should turn positive over the next year, but with widening divergences across countries for our base case scenarios. Projected government bond return expectations over the next 12 months look most attractive in Australia, Germany and the UK – where far too many rate hikes are priced in – compared to the US, where the Fed is more likely to follow through on most, but not all, discounted rate increases. Japan has the lowest expected returns, and the defensive properties of “low-beta” JGBs will be less necessary with global yield momentum set to peak in the latter half of 2022. Our Global Golden Rule Base Case Scenarios For The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Bottom Line: The return expectations over the next year stemming from our Global Golden Rule suggest the following country allocation recommendations in global government bond portfolios: maintain overweights in Australia, Germany and the UK, stay underweight the US and neutral Canada, but downgrade Japan to underweight. Feature Chart 1A Pause In The Global Bond Bear Market A Pause In The Global Bond Bear Market A Pause In The Global Bond Bear Market Global bond markets may finally be showing signs of settling down after a painful period of rising yields and high volatility. Government bond yields across the developed economies have fallen substantially over the past week as equity and credit markets have sold off, in a typical risk-off response to increased concerns over global growth momentum. For example, benchmark 10-year government yields have fallen by -32bps both the US and UK, -25bps in Germany and -22bps in Canada since the cyclical intraday high was reached on May 9. These moves are modest in the context of the cyclical bond bear market, with the Bloomberg Global Treasury index still down -12.1% year-to-date and -14.4% on a year-over-year basis (Chart 1). That painful selloff has been driven by expectations of intense monetary tightening in response to surging global inflation. However, last week’s release of US Consumer Price Index data for April confirmed that US goods inflation has peaked, a trend that we expect to follow suit in other countries (Chart 2). That will leave inflation momentum, and eventual interest rate hikes, to be driven more by domestic services inflation that will prove to be less correlated across countries over the next 6-12 months (Chart 3). Chart 2Inflation & Rate Hike Expectations Have Become Correlated. . . Inflation & Rate Hike Expectations Have Become Correlated. . . Inflation & Rate Hike Expectations Have Become Correlated. . . ​​​​​​ Chart 3. . .Making Our Global Golden Rule All About Inflation . . .Making Our Global Golden Rule All About Inflation . . .Making Our Global Golden Rule All About Inflation ​​​​​​ With that in mind, we revisit our framework for linking government bond returns to monetary policy outcomes versus expectations, the Global Golden Rule of Bond Investing. A Brief Overview Of The Global Golden Rule In September 2018, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.” This was an extension of a framework introduced by our sister service, US Bond Strategy, that links US Treasury returns (versus cash) to changes in the fed funds rate that were not already discounted in the US Overnight Index Swap (OIS) curve.1 The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields and Treasury returns. Related Report  Global Fixed Income StrategyRevisiting Our Global Golden Rule Of Bond Investing We discovered that relationship also held in other developed market countries. This gave us a framework to help project expected global bond returns simply based on a view for future central bank interest rate moves versus market expectations.2 Specific details on the calculation of the Global Golden Rule can be found in those original 2018 papers. In the following pages, we present the latest results of the Global Golden Rule for the US, Canada, Australia, the UK, the euro area and Japan. The set-up for the chart shown for each country is the same. We show the 12-month policy rate “surprise”, defined as the actual change in the central bank policy rate over the preceding 12-months versus the expected 12-month change in the policy rate from a year earlier extracted from OIS curves (a.k.a. our 12-month discounters). We then compare the 12-month policy rate surprise to the annual excess return over cash (treasury bills) of the Bloomberg government bond index for each country. We also show the 12-month policy rate surprise versus the 12-month change in the government bond index yield. The very strong historical correlation between those latter two series is the backbone of the Global Golden Rule framework. After that, we present tables showing expected yield changes and excess returns for various maturity points, as well as the overall government bond index, derived from the Global Golden Rule regressions. The expected change in yield is derived from regressions on the policy rate surprises, with different estimations done for each maturity point. In the tables, we show the results for different scenarios for changes in policy rates. For example, the row in the return tables labeled “+25bps” would show the expected yield changes and excess returns if the central bank for that particular country lifts the policy interest rate by +25bps over the next 12 months. Showing these scenarios allows us to pick the one that most closely correlates to our own expectation for central bank actions, translating that into government bond return expectations. Global Golden Rule: US Chart 4Risk/Reward Favors Less UST-Bearish Fed'Surprises' Risk/Reward Favors Less UST-Bearish Fed'Surprises' Risk/Reward Favors Less UST-Bearish Fed'Surprises' US Treasuries have delivered a painful loss of -7.8% versus cash over 12 months. Bearish outcomes of such magnitude were last seen during 1994 and 1999 when the Fed was aggressively lifting the funds rate. The Fed delivered a smaller hawkish surprise over the past year than those 1990s episodes, with a trailing 12-month policy rate surprise of -72bps. Thus, the Golden Rule underestimated losses realized by US Treasuries, as US bond yields moved to price in far more Fed tightening than what was expected one year ago. The US OIS curve now discounts +229bps of rate hikes over the next 12 months, taking the fed funds rate to 3.3% (Chart 4). That is a more aggressive profile than was laid out in the March 2022 Fed “dots”, where the median FOMC member projection called for the funds rate to climb to 2.8% in 2023. That means there is less scope for Fed rate hikes to surprise versus market expectations that are already very hawkish, at a time when US growth and inflation momentum is rolling over. Our base case calls for the Fed to deliver +200bps of rate increases over the next year, +50bps at the next two policy meetings followed by +25bps at the subsequent four meetings. That outcome produces a Golden Rule forecast of the overall US Treasury index yield falling -13bps, generating a total return of +3.73% (Tables 1 & 2). Table 1US: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 2US: Expected Changes In Treasury Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Canada Chart 5Canadian Bonds Selloff After A Hawkish BoC Canadian Bonds Selloff After A Hawkish BoC Canadian Bonds Selloff After A Hawkish BoC Canadian government bonds have sold off hard over the past 12 months, delivering an excess return over cash of -7.5% (Chart 5). That loss reflects the Bank of Canada’s (BoC) hawkish turn, but is a less severe outcome compared to other developed economy government bond markets that saw a major repricing of rate hike expectations like the US and Australia. Losses in the Canadian government bond market were consistent with the +34bps of hawkish surprises delivered by the BoC, which tightened by +75bps on a 12-month basis versus the +41bps expected by markets in May 2021. Rate expectations are highly aggressive on a forward basis. The Canadian OIS curve now discounts 210bps of interest rate increases over the next 12 months. However, high household debt in Canada, fueled by a relentlessly expanding housing bubble, will limit the ability of the BoC to match the Fed’s rate hikes over the next 6-12 months. Higher debt levels also imply a lower nominal neutral rate of interest, as the BoC has less room to hike before debt servicing costs become overly burdensome for overleveraged Canadian consumers. Our base case is that the BoC will deliver +150bps of tightening over the next 12 months. This produces a Golden Rule forecast of a decline in the overall Canadian government bond index yield of -17bps, delivering a projected total return of 4.52% (Tables 3 & 4). Table 3Canada: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 4Canada: Expected Changes In Government Bond Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Australia Chart 6Aggressive Rate Hike Expectations On A Forward Basis For Australia Aggressive Rate Hike Expectations On A Forward Basis For Australia Aggressive Rate Hike Expectations On A Forward Basis For Australia Australian government bonds have delivered a negative excess return over cash of -9.6% over the past year (Chart 6). This is the biggest sell-off among all the countries covered in our Global Golden Rule framework. The magnitude of those realized losses far exceeded what would have been predicted by the Golden Rule a year ago, with the Reserve Bank of Australia (RBA) delivering only a modest hawkish surprise. An unexpectedly high Australian headline inflation print of 5.1% in Q1 of this year led the RBA to deliver a surprise +25bps rate hike in April. This created a mild hawkish policy rate surprise of -17bps over the past 12 months, as only +8bps of tightening had been discounted in the Australian OIS curve in May 2021. The Australian OIS curve is now discounting 292bps of rate hikes over the next year, taking the cash rate to just over 3% - a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. The RBA appears confident in the Australian economy, forecasting the unemployment rate to reach a 50-year low around 3.5% in 2023. However, we believe the RBA will be more measured in its pace of rate increases over the next year than markets expect, as global traded goods inflation cools and Australian wages are still not overheating. According to the Golden Rule projections, our base case of +150bps of tightening will produce a decline in Australian government bond index yield of -92bps, delivering a projected total return of 9.29% (Tables 5 & 6). Table 5Australia: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 6Australia: Expected Changes In Government Bond Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: UK Chart 7The BoE Will Hike Less Than Markets Expect The BoE Will Hike Less Than Markets Expect The BoE Will Hike Less Than Markets Expect UK government bonds have gotten hit hard over the past year, delivering a negative excess return over cash of -7.9% - one of the worst performances seen over the past quarter century (Chart 7). The size of that loss was in line with the Global Golden Rule forecasts, given the magnitude of the rate shock seen in the UK. The Bank of England (BoE) hiked rates by 90bps over the past 12 months, which was a hawkish surprise of -79bps compared to what was discounted one year earlier. The UK OIS curve is now priced for another +139bps of rate hikes over the next year. This would take the BoE’s Bank Rate to 2.4%, a level that would push the UK unemployment rate up by two percentage points and lower UK inflation to below 2% within the next 2-3 years, according to the BoE’s own forecasting models. As we discussed in our report last week, where we upgraded our stance on UK Gilts to overweight, the neutral level of UK policy rates is between 1.5-2%, at best, with UK potential growth barely above 1%. Thus, markets are already pricing in a very restrictive monetary policy stance from the BoE that is unlikely to be fully delivered before UK growth and inflation decline sharply. Our base case calls for the BoE to deliver only another +75bps of hikes over the next year, which will produce a fall in the UK government bond index yield of -21bps and a total return of 4.12% (Tables 7 & 8). Table 7UK: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 8UK: Expected Changes In Gilt Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Germany Chart 8German Bunds Stand To Gain From An ECB Dovish Surprise German Bunds Stand To Gain From An ECB Dovish Surprise German Bunds Stand To Gain From An ECB Dovish Surprise German government bonds suffered major losses over the past year, underperforming cash by -8.5% over the past year. We saw no policy surprise from the European Central Bank (ECB) over that time relative to market expectations (Chart 8). The dramatic sell-off instead reflected surging expectations of future tightening as the euro area faces an energy-driven inflation spike. The trailing 12-month policy rate surprise for Germany (and the overall euro area) remains stuck near zero. However, markets now expect a very aggressive move by the ECB, discounting a full +156bps of tightening over the next 12 months. This would push the ECB’s main refinancing rate to levels last seen in the disastrous tightening cycle during the 2011 European debt crisis. As argued by our colleagues at BCA Research European Investment Strategy, the euro area is heading into a growth slowdown and energy inflation looks set to peak. Even if the hawks are able to sway the ECB Governing Council to begin hiking rates this summer, the slowing trajectory of growth and inflation make it highly unlikely that the ECB will deliver the full amount of tightening currently discounted. Our base case is that the ECB will deliver only +50bps of tightening over the next 12 months, enough to push the deposit rate out of negative territory to 0%. As shown in Tables 9 & 10, this is consistent with the Germany government bond index yield falling -55bps, delivering an index return of 5.07% over a 12-month horizon. Table 9Germany: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 10Germany: Expected Changes In Bund Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Japan Chart 9The Upside On A BoJ Dovish Surprise Is Limited The Upside On A BoJ Dovish Surprise Is Limited The Upside On A BoJ Dovish Surprise Is Limited Japanese government bonds (JGBs) have delivered an excess return versus cash of -1.8% over the past twelve months (Chart 9). The policy rate surprise was flat as the Bank of Japan (BoJ) kept the policy rate unchanged at -0.1%. Admittedly, the Golden Rule framework is poorly suited to project Japanese bond returns. The BoJ has been unable to lift policy rates for many years, while instituting yield curve control on 10-year JGBs since 2016 to anchor yields near zero. With no variability on policy rates or bond yields, a methodology that links bond returns to unexpected policy interest rate changes will have poor predictive power. However, rates traders are making some attempt to challenge the BoJ’s ultra-dovish posture. The Japan OIS curve now discounts +9bps of tightening, approximately enough to push the policy rate to zero, over the next 12 months. With the yen weakening rapidly and the cost of imported energy elevated, consumer price inflation in Tokyo (excluding fresh food) hit the BoJ’s 2% target in April. However, as evidenced in the minutes of the March BoJ meeting, policymakers see a sustainable inflation overshoot as unlikely. Our base case is the “Flat” scenarios shown in Tables 11 & 12, with the BoJ keeping policy rates unchanged for the next twelve months and delivering a slight dovish surprise. That generates a Golden Rule forecast of a -6bps fall in the Japanese government bond index yield, with a total return projection of 0.87%. Table 11Japan: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 12Japan: Expected Changes In JGB Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Investment Implications Of The Global Golden Rule Projections For all the countries discussed above, our base case calls for the respective central banks to deliver less tightening than markets are discounting over the next year. This suggests that government bonds should be expected to deliver positive returns versus cash, even as we expect multiple rate increases from all central banks except the BoJ. While this could argue for an above-benchmark duration stance at the overall global level, we prefer to translate the Global Golden Rule results via country allocations – as we have greater conviction on relative central bank moves in the current high inflation environment – while keeping overall global duration exposure at neutral. The return outcomes for our base case scenarios for the six countries in our Global Golden Rule framework are presented in Table 13. We show the expected returns both in local currency and hedged into US dollars, the latter allowing a comparison in common currency terms. In our base case scenarios, we expect Australian and German government bonds to deliver the strongest performance over the next year, followed by the UK, Canada, the US and Japan. Table 13Our Global Golden Rule Base Case Scenarios For The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Chart 10Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Our UK upgrade to overweight last week was a change to our strategic call on Gilts. Based on the results from our Global Golden Rule update, increased exposure to UK Gilts should be “funded” in a global bond portfolio by reducing exposure to Japan, with JGBs expected to deliver the weakest returns. Cutting JGB exposure also fits with the signal from our Global Duration Indicator, which is heralding a peak in global bond yield momentum in the latter half of 2022 (Chart 10). JGBs are typically a good “defensive” overweight country allocation in an environment of rising global bond yields. Persistently low Japanese inflation prevents the BoJ from credibly signaling rate hikes when other central banks like the Fed are lifting rates in response to stronger growth or overshooting inflation as is currently the case. The relative performance of Japan versus the Bloomberg Global Treasury benchmark index (in USD-hedged terms) is highly correlated to the year-over-year momentum of the overall level of global bond yields. With our Duration Indicator signaling a peak in yield momentum, we expect JGBs, which continue to exhibit a very low “beta” to changes in global bond yields, to underperform. Thus, this week we are downgrading our strategic allocation to Japan from overweight (4 out of 5) to underweight (2 out of 5). We view this as an offsetting recommendation to our UK upgrade from last week, while leaving our other country allocations unchanged. The result is that our country recommendations now line up with the expected returns from our Global Golden Rule, as can be seen in Table 13. That includes leaving the recommended US Treasury exposure at underweight, as we expect the Fed to deliver the smallest dovish surprise out of the central banks discussed in this report. We are adding both of the view changes made over the past two weeks, upgrading the UK and downgrading Japan, to our model bond portfolio as seen on pages 20-21. Bottom Line: Our Global Golden Rule suggests that developed market government bonds are expected to deliver positive returns over the next year as softening inflation momentum leads central banks to not fully deliver discounted rate hikes. Return expectations look most attractive in Australia, Germany and the UK, especially compared to the US and Japan.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Deborah Acri Research Associate deborah.acri@bcaresearch.com Footnotes 1      Please see BCA Research US Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcarearch.com. 2     Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25, 2018, available at gfis.bcaresearch.com. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Tactical Overlay Trades

Listen to a short summary of this report.     Executive Summary The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107       Short EUR/JPY 2022-05-12 133.278 120 137       Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon.       Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar Chart 2The Fed And The Dollar The Fed And The Dollar The Fed And The Dollar Chart 3The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? How Sustainable Is The Breakout How Sustainable Is The Breakout The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106.  Euro: A Recession Is Priced Chart 8Go Short EUR/JPY Go Short EUR/JPY Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months.  Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? A Capitulation In The Yen? A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY.  British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro.  Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon.  New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand.  A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk.   The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar.  Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent.  Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon.  Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Swiss Inflation Will Fall Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR.  The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside.  Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg.  Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside SEK Has Upside SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March.  The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year.  Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com   Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Fed, Bank of England (BoE) and Reserve Bank of Australia all hiked rates last week. The BoE, however, signaled a note of caution on future UK growth, given soaring energy prices and plunging consumer and business confidence.  Interest rate markets are pricing in a peak in UK policy rates over the next year near 2.5%, above realistic estimates of neutral that are more in the 1.5-2% range. UK productivity and potential growth remain too weak to support a higher neutral rate than that. With the BoE forecasting near recessionary conditions over the next couple of years if those market-implied rate hikes come to fruition, the time is right to increase exposure to UK government bonds in global fixed income portfolios. UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Not All Central Bankers Can Credibly Restore Credibility Chart 1Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Three more central bank meetings, three more rate hikes. Last week brought a 50bp hike from the Fed, a 25bp hike – the first of this tightening cycle – by the Reserve Bank of Australia (RBA) and a 25bp rate increase from the Bank of England (BoE). The Fed and RBA moves did little to stabilize the government bond bear markets in the US and Australia, but the BoE was able to provide a temporary reprieve for the Gilt selloff by playing up potential UK recession (stagflation?) risks. Bond yields worldwide remains laser focused on high global inflation and the associated monetary policy response that will be needed to stabilize inflation expectations (Chart 1). That includes both interest rate hikes and reducing the size of bloated central bank balance sheets. The threat of such “double tightening” is weighing on global growth expectations and risk asset valuations. The MSCI World equity index is down -6.4% (in USD terms) so far in the Q2/2022 and down -14.5% since the mid-November/2021 peak. Although in a more mitigated way, credit markets are also being impacted, with the Bloomberg Global High-Yield index down -2.6% so far in Q2 on an excess return basis versus government bonds. Rate hike expectations have started to catch up to elevated inflation expectations, at least according to inflation linked bonds. The yield on 10-year US TIPS now sits at +0.29%, a huge swing from the -1% level seen just one month ago (Chart 2). The 10-year real yield is even higher in Canada (+0.81%) where the Bank of Canada just delivered its own 50bp rate hike in April. On the other hand, 10-year real yields remain deeply below 0% in Europe and the UK, where central bankers have been providing less explicit guidance on future rate hikes and asset purchase reductions compared to the Fed or Bank of Canada. Interest rate markets remain reluctant to price in significantly positive real policy interest rates at the peak of the current tightening cycle. Our proxy for the real terminal rate expectation, the 5-year/5-year overnight index swap rate (OIS) minus the 5-year/5-year CPI swap rate, is only +0.18% in the US. It is still deeply negative in Europe (-1.53%) and the UK (-0.97%). Our estimates of the term premium component of 10-year government bond yields in those three markets is rising alongside interest rate expectations yet remains deeply negative in Europe and the UK (Chart 3). Chart 2Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock ​​​​​​ Chart 3Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates ​​​​​​ Of those three major bond markets, we see the UK term premium as being the least likely to see additional upward repricing, with the BoE less likely than the Fed or ECB to push for an aggressively smaller balance sheet given domestic economic risks. UK Rate Expectations Are Too Hawkish Chart 4Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves The Bank of England raised rates by 25bps last week, pushing Bank Rate to a 13-year high of 1.0%. The decision was a 6-3 majority, with three Monetary Policy Committee (MPC) members calling for a 50bp hike – matching recent moves by other G-10 central banks like the Fed and Bank of Canada – given tight UK capacity constraints (i.e. low unemployment) and high realized inflation. The MPC noted that additional rate increases would likely be necessary to tame very high UK inflation, a message confirmed by the elevated level of our UK Central Bank Monitor (Chart 4). However, the new economic forecasts presented by the BoE painted a gloomy picture on UK growth, raising the risks of a recession even as UK inflation is expected to continue climbing to a 10% peak in late 2022 on the back of high energy prices.1 Strictly looking at current inflation, the case for the BoE to continue hiking rates is obvious. Yet the BoE may now be placing more weight on the downside risks to growth from the energy shock, at a time when fiscal tightening is no longer providing stimulus. In the press conference following last week’s MPC meeting, BoE Governor Andrew Bailey noted the difficult situation policymakers are facing given the huge surge in energy prices that is fueling inflation while also weighing on household and business real incomes. So what is “neutral” anyway? Related Report  Global Fixed Income StrategyThe UK Leads The Way The BoE is one of the least transparent major central banks when it comes to providing guidance on what it thinks the neutral policy rate is. Market participants are left to arrive at their own conclusions and those can vary substantially, as is currently the case. The UK OIS curve is discounting a peak in rates of 2.72% in 2023 and discounting rate cuts after that starting in 2024. Yet the respondents to the BoE’s new Market Participants Survey are calling for a much lower trajectory with rates peaking at 1.75% before falling to 1.5% in 2024 (Chart 5). Those rate levels are in the lower half of the range of longer-run neutral rate estimates from the same Market Participants Survey, between 1.5% and 2.0% (the shaded box in the chart). Chart 5UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Chart 6Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Combining the messages from the OIS curve and the Survey, markets are pricing in a path for the BoE Bank Rate that will become restrictive by mid-2023, with another 172bps of rate hikes. The BoE uses market pricing for future interest rates in its economic forecasts. The Bank’s models suggest that a move to raise rates to 2.5% in response to high UK inflation, as markets are discounting, would result in a severe UK downturn that would both push up unemployment from the current 3.7% to 5.4% by Q2/2025 (Chart 6). Headline inflation would plunge to 1.3% over the same period as the UK output gap widens to -2.25% of GDP from the current “excess demand” level of +0.5%. Oddly enough, the BoE is only forecasting a flat profile for real GDP growth over that entire three-year forecasting period, although there will clearly be some negative GDP prints during that period to generate such a massively disinflationary outcome. A mixed picture on UK growth Currently, the UK economy is flashing some warning signs on growth momentum. The UK manufacturing PMI was 55.8 in April, still well above the 50 level indicating growth but 9.8 pts below the cyclical peak in 2021 (Chart 7). The services PMI is in better shape at 58.9, but it did dip lower in the latest reading. The GfK consumer confidence index has fallen sharply in response to contacting real household income growth, reaching the second-lowest reading in the history of the series dating back to 1974 in April. This is a warning sign for consumer spending – retail sales fell in April for the first time in fifteen months (middle panel). Business confidence is also impacted by the high costs of both energy and labor that is squeezing profit margins. UK real investment spending is nearly contracting on a year-over-year basis, despite the robust readings on investment intentions from the BoEs’ Agents Survey of UK businesses (bottom panel).UK firms are facing higher wage costs at a time of very tight labor market and robust labor demand. The BoE estimates that UK private sector wage growth, after adjusting for compositional effects related to the pandemic, will accelerate to 5.1% by the end of Q2/2022 (Chart 8). Chart 7UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds ​​​​​​ Chart 8UK Labor Market Remains Healthy UK Labor Market Remains Healthy UK Labor Market Remains Healthy ​​​​​​ Chart 9Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? A robust labor market and quickening wage growth is forcing the BoE to maintain a relatively hawkish bias at a time of high energy inflation, even with the growth outlook darkening in the central bank’s own forecasts. Booming house prices are also making the central bank’s job more challenging. The annual growth rate of the Nationwide UK house price index reached 12.4%, a 17-year high, in March. However, rising mortgage rates and declining household real incomes will likely begin to eat into housing demand and, eventually, help slow the rapid pace of house price growth (Chart 9, bottom panel). Summing it all up, the overall UK inflation picture, including wages and housing costs in addition to energy prices and durable goods prices, will force the BoE to deliver a few more rate hikes before year-end before reaching a peak level that is lower than current market pricing. The neutral UK interest rate is likely very low Chart 10Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate The UK economy has suffered from structurally low potential economic growth dating back to the Brexit referendum in 2016. UK businesses stopped investing in the face of the uncertainty over the UK’s relationship with Europe. There has basically been no growth in UK fixed investment over the past five years. In response, UK productivity has only grown an annualized 0.9% over that same period (Chart 10) and the OECD’s estimate of UK potential GDP growth has been cut from 2% to 1.1%. With such low potential growth, the neutral BoE policy interest rate is likely even lower than the 1.5-2% range of estimates from the BoE’s Market Participant Survey. Tighter fiscal policy also lowers the neutral UK interest rate, with the UK Office of Budget Responsibility forecasting a narrowing of the UK budget deficit of -13.6 percentage points between the 2021 peak and 2027 (bottom panel). A flat UK Gilt curve is also a sign that the neutral interest rate is quite low. The 2-year/10-year Gilt curve now sits at a mere -49bps with Bank Rate only at 1% (Chart 11). While this is modestly steeper from the near-inversion of the curve seen at the start of 2022, a very flat curve at a nominal policy rate of only 1% suggests that the neutral rate is not far from the current level. Sluggish UK equity market performance and widening UK corporate credit spreads also argue that Bank Rate may already be turning restrictive, although a lower trade-weighted pound is helping to mitigate the overall tightening of UK financial conditions. Chart 11UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) ​​​​​​ Chart 12Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does ​​​​​​ In the end, the pressure on the BoE to tighten will not ease until UK inflation peaks. The BoE is suffering a severe credibility crisis, with its own public opinion survey showing the deepest level of public dissatisfaction with the bank since the Global Financial Crisis (Chart 12). Inflation expectations are at similar levels that prevailed during that period, although the unique nature of the current inflation upturn, fueled by global supply-chain squeezes and war-related boosts to commodity prices, will likely prevent a repeat of the relatively fast reversal of inflation expectations seen after the Global Financial Crisis. Investment Implications – Get Ready For Gilt Outperformance Chart 13Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight With the BoE already pushing Bank Rate towards a plausible neutral range, we do not expect many more rate hikes in the UK. Our base case is that the BoE hikes 2-3 more times by year-end, pushing Bank Rate to 1.5-1.75%, before pausing. This would represent a lower peak in policy rates than currently priced in the UK OIS curve. That is a relatively dovish outcome that typically leads to positive performance for a government bond market according to our “Global Golden Rule” framework, which we will revisit in next week’s Strategy Report. For now, however, we see a strong case to turn more positive on UK Gilts, with the BoE likely to deliver fewer rate hikes than discounted (Chart 13). The BoE is also far less likely to begin reducing its balance sheet by selling its Gilt holdings back to the market. BoE Governor Bailey strongly hinted last week that such aggressive quantitative tightening (QT) was not a given, even after the Bank research staff presents its proposals to the MPC in August. A delay in QT would also be a factor boosting UK Gilt performance versus other developed economy bond markets where more aggressive reductions in central bank balance sheets are more likely, like the US and potentially even the euro area. This week, we are upgrading our recommended strategic UK weighting from underweight to overweight. In next week’s report, we will consider the proper allocation for the UK within our model bond portfolio, after reviewing potential bond return forecasts stemming from our Global Golden Rule. Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1      The mechanical way that the UK government’s energy price regulator, Ofgem, sets price caps on retail gas and electricity costs - based on changes in wholesale energy costs implied by futures curves – means that UK household energy prices will rise by 40% in October, according to BoE estimates. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts Tactical Overlay Trades

Listen to a short summary of this report.       Executive Summary Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities in late February but see the current level of stock prices as offering enough upside to warrant an overweight. Global equities are now trading at 15.6-times forward earnings, and only 12.6-times outside the US. More importantly, the forces that pushed down stock prices are starting to abate: The war in Ukraine no longer seems likely to devolve into a broader conflict; the number of new Covid cases in China has fallen by half; and global inflation has peaked. The next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. The “Last Hurrah” for equities is coming. We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, countertrend rallies are likely. To express this view, we recommend taking partial profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020) and our short Bitcoin position (up 98% based on our exponential shorting technique). Bottom Line: Global equities are heading towards a “last Hurrah” starting in the second half of this year. Tactically upgrade stocks to overweight.   Feature Dear Client, We published a Special Alert early this afternoon tactically upgrading global equities to overweight. As promised, the enclosed report elaborates on our view change. Best regards, Peter Berezin Restore Tactical Overweight On Global Equities Chart 1Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off We tactically downgraded global equities from overweight to neutral on February 28th. The war in Ukraine, the Covid outbreak in China, and most importantly, the rise in bond yields have kept us on the sidelines ever since. At this point, however, the outlook for stocks has brightened, and thus we are restoring our tactical (3-month) overweight to stocks so that it is consistent with our bullish 12-month cyclical view. First, valuations have discounted much of the bad news. After the recent sell-off, global equities are trading at 15.6-times forward earnings (Chart 1). Outside the US, they trade at only 12.6-times forward earnings. Second, the forces that pushed down stock prices are starting to abate. The war in Ukraine is approaching a stalemate, with Russian troops unable to take much of the country, let alone seriously threaten regional neighbours. A European embargo on Russian oil is likely but will be watered down significantly before it is implemented. European officials have shied away from banning Russian natural gas, an action that would have much more severe economic implications. While still very high in absolute terms, December-2022 European natural gas futures are down 36% from their peak on March 7 (Chart 2). The 7-day average of new Covid cases in China has fallen by more than half since late April (Chart 3). Considering that a significant fraction of China’s elderly population is unvaccinated, the authorities will continue to play whack-a-mole with the virus for the next few months (Chart 4). Fortunately, Chinese domestic production of Pfizer’s Paxlovid anti-Covid drug is starting to ramp up, which should allow for some easing in lockdown measures later this year. Chart 2European Natural Gas Futures Have Come Off The Boil European Natural Gas Futures Have Come Off The Boil European Natural Gas Futures Have Come Off The Boil Chart 3Covid Cases Are Falling In China… It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight The 20th Chinese National Party Congress is slated for this fall. In the lead-up to the Congress, it is likely that the government will move to diffuse social tensions over its handling of the pandemic by showering the economy with stimulus funds. Of note, the credit impulse has already turned higher, which bodes well for both Chinese growth and growth abroad (Chart 5). Chart 4… But Low Vaccination Rates Among The Elderly Remain A Risk It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Chart 5A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World A Rebound In China's Credit Impulse Bodes Well For China And The Rest Of The World   Inflation Is Peaking On the inflation front, the data flow has gone from unambiguously bad to neutral (and perhaps even slightly positive). In the US, core goods inflation fell by 0.4% month-over-month in April, the first outright decline in core goods prices since February 2021. The Manheim Used Vehicle Value Index has crested and is now 6.4% below its January peak (Chart 6). Global shipping rates have moved up a bit recently on the back of Chinese port shutdowns but remain well below their highs earlier this year (Chart 7). Chart 6Used Car Prices Appear To Have Peaked Used Car Prices Appear To Have Peaked Used Car Prices Appear To Have Peaked Chart 7Global Shipping Rates Are Well Off Their Highs Global Shipping Rates Are Well Off Their Highs Global Shipping Rates Are Well Off Their Highs It Is The Composition Of Spending That Is Distorted Despite the often-heard claim that US consumer spending is well above trend, the reality is that spending is more or less in line with its pre-pandemic trend (Chart 8). It is the composition of spending that is out of line: Goods spending is well above trend while services spending is well below. One might think that only the overall level of spending should matter for inflation, and that the composition of spending is irrelevant. However, this ignores the reality that services prices are generally stickier than goods prices. Companies that sold fitness equipment during the pandemic had no qualms about raising prices. In contrast, gyms barely cut prices, figuring that lower membership fees would do little to drive new business through the door (Chart 9). Chart 8Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 9Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices This asymmetry matters, and it suggests that goods inflation should continue to fall over the coming months as the composition of spending shifts back to services. A Lull In Wage Growth Wages are the most important determinant of services inflation. While it is too early to be certain, the latest data suggest that wage growth has peaked. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 10). Assuming productivity growth of around 1.5%, this is consistent with inflation of only slightly more than 2%. Nominal wage growth is a function of both labor market slack and expected inflation. Slack should increase modestly during the rest of the year as labor participation recovers. Chart 11 shows that the labor force participation rate is still about 0.9 percentage points below where one would expect it to be, even adjusting for an aging population and increased early retirements. Chart 10Wage Growth Seems To Be Topping Out Wage Growth Seems To Be Topping Out Wage Growth Seems To Be Topping Out Chart 11Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Labor Participation Has Further Scope To Recover Employment has been particularly depressed among lower-wage workers (Chart 12). This should change as more low-wage workers exhaust their savings and are forced to seek employment. According to the Fed, the lowest-paid 20% of workers are the only group to have seen their bank deposits dwindle since mid-2021 (Chart 13). Chart 12More Low-Wage Employees Will Return To Work More Low-Wage Employees Will Return To Work More Low-Wage Employees Will Return To Work Chart 13The Savings Of Low-Wage Workers Are Dwindling The Savings Of Low-Wage Workers Are Dwindling The Savings Of Low-Wage Workers Are Dwindling Inflation expectations should come down as goods inflation recedes and oil prices come off their highs (Chart 14). Bob Ryan, BCA’s Chief Commodity Strategist, sees the price of Brent averaging $86/bbl in the second half of this year, down 16% from current levels.  Central Banks Will Dial Back The Hawkishness With inflation set to fall over the remainder of the year, and financial markets showing increasing signs of stress, the Fed and other central banks will adopt a softer tone. It is worth noting that the median terminal dot for the Fed funds rate actually declined from 2.5% to 2.4% in the March Summary of Economic Projections (Chart 15). Given that markets expect US interest rates to rise to 3.25% in 2023, the Fed may not want investors to further rachet up rate expectations. Chart 14US Inflation Expectations Should Recede If Oil Prices Drop US Inflation Expectations Should Recede If Oil Prices Drop US Inflation Expectations Should Recede If Oil Prices Drop Chart 15Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral Rate Expectations Have Moved Well Above The Fed's Estimate of Neutral   The Bank of England has already veered in a more dovish direction. Its latest forecast, released on May 5, showed real GDP contracting slightly in 2023. Based on market interest rate expectations, the BoE sees headline inflation falling to 1.5% by end-2024, below its target of 2%. Even assuming that interest rates remain at 1%, the BoE believes that inflation will only be slightly above 2% at the end of 2024, implying little need for incremental policy tightening. Not surprisingly, the pound has sold off. We have been tactically short GBP/USD but are using this opportunity to turn tactically neutral. Given favorable valuations, we like the pound over the long run. Chart 16Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend Spending In The Euro Area Is Well Below Its Pre-Pandemic Trend The euro area provides a good example of the dangers of focusing too much on short-term inflation dynamics. Supply-side disruptions stemming from the pandemic and the war in Ukraine have weighed on European growth this year. Yet, those very same factors have also pushed up inflation. Harmonized inflation across the euro area reached 7.5% in April, the highest since the launch of the common currency. The ECB is eager to put some distance between policy rates and the zero bound. However, there is little need for significant tightening. Unlike in the US, spending in the euro area is well below its pre-pandemic trend (Chart 16). If anything, more inflation would be welcome since that would give the ECB scope to bring real rates further into negative territory if economic conditions warrant it. To its credit, the Bank of Japan has stuck with its yield curve control system, even as bond yields have risen elsewhere in the world. Japan’s currency has weakened but given that inflation expectations are too low, and virtually all of its debt is denominated in yen, that is hardly a bad thing. Too Late? Has the surge in bond yields already done enough damage to the global economy to make a recession inevitable? We do not think so. As noted above, much of the recent harm has been caused by various dislocations, namely the war in Ukraine and the ongoing effects of the pandemic. As these dislocations dissipate, inflation will fall and global growth will recover. Despite the hoopla over how the US economy contracted in the first quarter, real private final sales to domestic purchasers (a measure of GDP growth that strips out the effects of changes in government spending, inventories, and net exports) rose by 3.7% at an annualized rate. As Table 1 shows, this measure of economic activity has the highest predictive power for GDP growth one-quarter ahead. Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.7% In Q1 It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Meanwhile, and completely overlooked at this point, S&P 500 earnings have come in 7.3% above expectations so far in Q1, with nearly 80% of S&P 500 companies surprising on the upside. Earnings are up 10.4% year-over-year in Q1. Sales are up 13.6%. Looking out to Q4 of 2022, S&P companies are expected to earn $60.93 in EPS, up 4.3% from what analysts expected at the start of the year. It is also worth noting that homebuilder stocks have basically been flat over the past 30 days, even as the S&P 500 has dropped by nearly 10% over this period. Housing is the most interest rate-sensitive sector of the economy. With the homeowner vacancy rate at record low levels, even today’s mortgage rates may not be enough to push the economy into recession (Chart 17). Economic vulnerabilities are greater outside the US. Nevertheless, there is enough pent-up demand on both the consumer and capital spending side to sustain growth. The Last Hurrah How long will the “Goldilocks” period of falling inflation and supply-side driven growth last? Our guess is about 18 months, starting this summer and lasting until the end of 2023. Unfortunately, as is often the case, the benign environment that will emerge in the second half of this year will sow the seeds of its own demise. Real wages are currently falling across the major economies (Chart 18). That has dampened consumer confidence and spending. However, as inflation comes down, real wage growth will turn positive. This will stoke demand, leading to a reacceleration in inflation, most likely in late 2023 or early 2024. Chart 17Tight Supply Makes Housing More Resilient Tight Supply Makes Housing More Resilient Tight Supply Makes Housing More Resilient Chart 18Real Wages Are Falling In Most Countries Real Wages Are Falling In Most Countries Real Wages Are Falling In Most Countries   In the end, central banks will discover that the neutral rate of interest is higher than they thought. That is good news for stocks in the short-to-medium run because it means that forthcoming rate hikes will not induce a recession. Down the road, however, a higher neutral rate means that investors will eventually need to value stocks using a higher discount rate. It also means that the disinflation we envision over the next 18 months will not last. All this puts us in the rather lonely “transitory transitory” camp: We think much of today’s high inflation will prove to be transitory, but the transitory nature of that inflation will itself be transitory. Be that as it may, the next 18 months of falling inflation and receding recession fears could see stocks recover much of their losses. For most investors, that is too long a period to sit on the sidelines. The “Last Hurrah” for equities is coming. Taking Partial Profits On Our Short Treasury, Long Value/Growth, And Short Bitcoin Trades We continue to think that over a 5-year horizon, bond yields will rise from current levels, value stocks will outperform growth stocks, and crypto prices will fall. However, with the “Last Hurrah” approaching, countertrend rallies are likely. To express this view, we recommend taking half profits on our short 10-year Treasury trade recommendation (up 9.3% from an initial entry yield of 1.45% on June 30, 2021). We are also halving our long global value/growth position (up 20.1% since inception on December 10, 2020), and our short Bitcoin position (up 98% based on our exponential shorting technique). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight Special Trade Recommendations Current MacroQuant Model Scores It’s Time To Buy: Tactically Upgrading Global Equities To Overweight It’s Time To Buy: Tactically Upgrading Global Equities To Overweight

Executive Summary The US Still Dominates Economic Output The US Still Dominates Economic Output The US Still Dominates Economic Output While the Ukraine war has been positive for the greenback, there is a slow tectonic shift away from the dollar as China rethinks holding concentrated foreign currency reserves. In the near term, the dollar faces positive macro variables and still-rising geopolitical tensions. Longer term, as global trade slows and countries gravitate into regional trading blocs, the dollar will need to fall to narrow the US trade deficit. By the same token, the Chinese RMB could weaken in the near term but will stabilize longer term. China will promote its currency across Asia. Currency volatility will take a step-function higher in this new paradigm. Winners will be the currencies of small open economies, especially in resource-rich nations. Trade Recommendation Inception Date Return LONG GOLD 2019-12-06 27.7% Bottom Line: Cyclical forces continue to underpin the dollar, such as rising US interest rates, a slowdown in global growth, and a safe haven premium from still-high geopolitical tensions. That said, the dollar is overbought, expensive, and vulnerable to reserve diversification over the longer term. While tactical long positions make sense, strategic investors should not chase the dollar higher. Feature Currency market action this week focused on two key central bank meetings: the Federal Reserve and the Bank of England. The Fed raised rates by 50 basis points while the BoE raised by 25 points, yet the market expectation differs. In the US, markets imply that the Fed can keep real interest positive while engineering a soft landing in the economy. In the UK (and Euro Area), markets see more acute stagflationary risks and assign a higher probability to a policy error. This situation, together with rising geopolitical risk, has put a bid under the dollar. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Brewing in the background is the prospect that the Ukraine war and US sanctions on Russia could have longer-term consequences on the dollar. Specifically, Russia and China are now locked into a geopolitical partnership to undermine US geopolitical dominance, including the dollar’s supremacy. While this discussion will inevitably come with some speculation about what will happen in the future, what does the evidence say so far? More importantly, what are some profitable investment opportunities that could arise from any shift? The Russo-Chinese Rebellion Chart 1The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending From Russia’s and China’s point of view, the United States threatens to establish global hegemony. The US possesses the world’s largest economy and most sophisticated military. It has largely maintained its preponderance in these spheres despite the rise of China, the resurgence of Russia, and the formation of the European Union as a geopolitical entity (Chart 1). If the US succeeds in its current endeavor of crippling Russia’s economy and surrounding it with NATO military allies, the world will be even more imbalanced in terms of power, while China will be isolated and insecure. To illustrate this point, NATO’s military spending is much higher than that of the Shanghai Cooperation Organization (SCO), which is not nearly as developed a military alliance (Chart 2). Hence Russia and China believe they must take action to counter the US and establish a global balance of power. When Presidents Vladimir Putin and Xi Jinping met on February 4 to declare that their strategic partnership will suffer “no limits,” which means no military limits, they declared a new multipolar era and warned against US domination under the guise of liberalism. If China allows Putin to fail in his conflict with the West, the Russian regime will eventually undergo a major leadership and policy change and China will become isolated. Whereas if China accepts Russia’s current strategic overture, China will be fortified. Russia can be immensely supportive of China’s Eurasian strategy to bypass US maritime dominance and improve supply security (Chart 3). Chart 2NATO Vs SCO: US Threat Of Dominance FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The consequence of this Russo-Chinese alliance will be to transact in a currency that falls outside sanctions by the US. This will be no easy feat. The US dollar still monopolizes the world’s monetary system, even though the US is likely to lose economic clout over time.  Chart 3China Cannot Reject Russia FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​ De-Dollarization And A Brewing USD Crisis? Fact Versus Fiction A reserve currency must serve the three basic functions of money on a global scale – providing a store of value, unit of account, and accepted medium of exchange. This status gives the dominant reserve currency an “exorbitant privilege,” a range of advantages including the ability to run persistent current account deficits and impose devastating sanctions on geopolitical rivals. Since the turn of the century, the US has struggled to maintain domestic political stability and has failed to deter challenges to its global leadership posed by Russia, China, and lesser powers. Lacking public support for foreign military adventures after Iraq and Afghanistan, Washington turned to economic sanctions to try to influence the behavior of other states. The results have been mixed in terms of geopolitics but cumulatively they have been neutral or positive for the trade-weighted dollar. The US adopted harsh sanctions against North Korea in 2005, Iran in 2010, Russia in 2012, Venezuela in 2015, and China in 2018. The primary trend in the dollar was never altered (Chart 4). Chart 4A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar Yet sweeping sanctions against Russia and China are qualitatively different from other sanctions– as they are among the world’s great powers. The extraordinary sanctions on Russia in 2022 – including cutting off its access to US dollar reserves – have proven deeply unsettling for China and other nations that fear they might someday end up on the wrong side of the US’s foreign policy. Russia’s own experience proves that diversification away from the dollar is likely to occur. From a peak of 47% in 2007, Russia reduced its dollar-denominated foreign exchange reserves to 16%. It cut its Treasury holdings from a peak of over 35% of international reserves to less than 1% today. Meanwhile Russia increased its gold holdings from 2% in 2008 to 20% (Chart 5). The Russians accelerated their diversification away from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. However, the world is familiar with Russian economic isolation. The West embargoed the USSR throughout the Cold War from 1949-1991. The dollar rose to prominence during this period, so it is not intuitive that Russia’s latest withdrawal from the global economy will enable other countries to abandon the dollar when they have failed in the past due to lack of alternatives. What is clear is that there is no clean or easy exit today from a dollar-denominated financial system. But there are a few lessons from Russia: The ruble has recouped all the losses since the implementation of sanctions. It runs a large current account surplus and has stemmed capital outflows. Another factor has been a sharp reduction in its dependence on the dollar. This will cushion the inflationary impact of US sanctions. Going forward, Russia will be much more insulated from the US dollar but at a terrible cost to potential economic growth (Chart 6). A dearth of US dollar capex into Russia will cripple productivity growth. The lesson for other US rivals will be to take economic stability into account when engaging in geopolitical rivalry.  Chart 5Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... The dollar has been unfazed by the Russian debacle. The victims have been other reserve currencies such as the euro, British pound, and Japanese yen, which are engulfed in an energy crisis from Russia’s actions.  Chart 6...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ​​​​​​ The key question that matters for investors will be what China will do. As one of the largest holders of US Treasurys, a destabilizing exit would have dramatic currency market impacts and could backfire on China. The trick will be to continue exiting this system without precipitating domestic instability. What Will China Do? China has learned two critical lessons from the Russo-Ukrainian conflict, with regard to raising the appeal of the RMB. First, the economic impact of US sanctions can still be devastating even when you have diversified out of dollars. Second, access to commodities is ever more important. As such, any strategy China chooses will need to mitigate these risks. China started diversifying away from the dollar in 2011 and today holds $1.05 trillion in US Treasurys. A little less than half of its foreign exchange reserves are denominated in dollars (Chart 7). This has been a gradual diversification that has not upended the current monetary regime. More importantly, China’s diversification accounts for the bulk of the shift by non-allies away from treasuries. Their share of foreign-held treasuries has fallen from 41% in 2009 to 23% today (Chart 8). Chart 7China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings ​​​​​​ Chart 8US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... ​​​​​​ China’s diversification has helped drive down the overall foreign share of US government debt holdings (excluding domestic central banks) from close to 50% in the middle of the last decade to 36% today (Chart 9). It has also weighed on the dollar. China can and will speed up its diversification from the dollar in the wake of the Ukraine war. While Americans will say that China only need fear such sanctions if it attacks Taiwan or other countries, China will not rest assured. Beijing must respond to US capability, not the Biden Administration’s stated intentions. A new Republican administration could arise as soon as January 2025 and take the offensive against China. The US and China are already engaged in great power rivalry and Beijing cannot afford to substitute hope for strategy. China ran a $224 billion current account surplus in 2021, so part of its strategy could be to reduce the pool of savings that need to be recycled every year into global assets. Since 2007 China has sent large amounts of outward direct investment into the world to acquire real assets and natural resources. The Xi administration tried to bring coherence to this outward investment by prioritizing different countries and investments adhere to China’s economic and strategic aims. The Belt and Road Initiative is the symbol of this process (Chart 10). Going forward, China will continue this process. It will also recycle more of its savings at home by increasing investment in critical industries such as energy security, semiconductors, and defense. Chart 9...But A Slow Diversification From US Debt Persists FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The key priorities will remain a Eurasian strategy of circumventing the US navy. Building natural gas pipelines and other infrastructure to link up with Russia is an obvious area of emphasis, although it will involve tough negotiations with Moscow. China will also prioritize Central Asia, the Middle East, South Asia, and mainland Southeast Asia as areas where its influence can grow with limited intervention by the US and its allies (Chart 11). Chart 10The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress ​​​​​​   Chart 11China Outward Investment Will Need To Be Strategic FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict Chart 12The RMB Could Dominate Intra-Regional Asean Trade FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict As China invests more at home and in other countries, financing and invoicing deals in the renminbi will grow. While the dollar is the transactional currency globally, it is far less relevant when considering local trading blocs. The euro dominates intra-European trade, suggesting China can try to expand RMB invoicing for intra-Asian trade (Chart 12). Even then, however, the yuan faces serious obstacles from China’s inability or unwillingness to extend security guarantees to its partners, failure shift the economic model to consumerism, persistent currency controls, closed capital account, and geopolitical competition with the United States. Investors should pay close attention to shifts occurring at the margin. The number of bilateral swap lines offered to foreign central banks by the People’s Bank of China has grown (Chart 13), with a total amount of around 4 trillion yuan. This allows the PBoC to use its massive foreign exchange reserves, worth about US$3.2 trillion, to back yuan liabilities. As China continues to grow and increases the share of RMB trade within its sphere of influence, the yuan will rise as an invoicing currency (Chart 14). This could take years, even decades, but a shift is already underway. Chart 13The People's Bank Of Asia? FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​​ Chart 14China Is Growing In Economic Importance China Is Growing In Economic Importance China Is Growing In Economic Importance ​​​​​​ In the near term, any US sanctions on China will hurt the RMB. Combined with hypo-globalization, China’s zero-Covid policy, narrowing interest rate differentials, and flight from Chinese assets, it is too soon to be positive on the RMB in the context of US-China confrontation (Chart 15). Longer term, China’s ability to ascend the reserve currency ladder will require a more radical change in Chinese policy to move the dollar. Chart 15CNY And US Sanctions CNY And US Sanctions CNY And US Sanctions Where Does The Euro Fit In? The biggest competitor to the US dollar is the euro, which took the largest chunk out of the US’s share of the global currency reserve basket in recent decades (Chart 16). Yet the EU could suffer a long-term loss of security, productivity, and stability from Russia’s invasion of Ukraine and the ensuing energy cutoff with Russia. Chart 16The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The EU will have to spend more on energy security and national defense. This will lead to an increase in debt securities that other countries could buy, which offers a way for countries to diversify from the dollar. However, Europe does not provide China or Russia with protection from US sanctions. The EU is allied with the US, it imposed sanctions on Russia along with the US, and like the US is pursuing extra-territorial law enforcement with its sanctions. When the US withdrew from the 2015 Iran nuclear deal, the EU disagreed technically, but in practice it enforced the sanctions anyway. The euro is hardly a safer reserve currency than sterling or the yen for countries looking to quarrel with the United States. The fact is that all of these allied states are likely to cooperate together in the event that any other state attempts to revise the global order as Russia has done. Not necessarily because they are democracies and share similar values but because they derive their national security from the US and its alliance system. The takeaway is that the euro will become a buying opportunity if and when the security environment stabilizes. Then diversification into the euro will occur. But it will not become a landslide that unseats the dollar, since the euro will still have a higher geopolitical risk premium. Investment Takeaways The historical evidence suggests that US sanctions have not weighed on the dollar. In the case of the Russo-Ukrainian conflict, it has been positive for the greenback. That said, there is a slow tectonic shift from the dollar, as each economic powerhouse evaluates the merits of holding concentrated foreign currency reserves. In the near term, the dollar will continue to be driven by traditional economic variables – global growth, real interest rate differentials, and the resilience of the US economy. That remains a positive. Geopolitical tensions reinforce the dollar’s current rally. Longer term, as globalization deteriorates and countries gravitate into regional trading blocs, the dollar will need to adjust lower to narrow the US trade deficit. By the same token, the RMB could weaken in the near term but will need to stabilize longer term, if Beijing wants it to be considered an anchor and store of value for other Asian currencies. Chart 17Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises The key takeaway is that currency volatility will take a step-function higher in this new paradigm. The winners could be the currencies of small open economies, especially in resource-rich nations. A world in which economic powers increasingly pursue national interests is likely to be inflationary. These powers will deplete the external pool of global savings, as current account balances wind down in favor of national and strategic interests. They will also likely encourage the demand for anti-fiat assets as currency volatility takes a step-function higher. Gold is likely to do well is this environment, but silver could be on the cusp of an explosion higher. The metal has found some measure of support around $22-23 per ounce even as manufacturing bottlenecks have hammered industrial demand. Long-only investors should hold both gold and silver, but a short gold/silver position makes sense both economically and from a valuation standpoint (Chart 17). Geopolitical Housekeeping: We are closing our Long FTSE 100 / Short DM-ex-US Equities trade for a gain of 19.5%. We still favor this trade cyclically and will look to reinstate it at a future date. We are also booking gains on our short TWD-USD trade for a return of 5.8% — though we remain short Taiwanese equities and continue to expect a fourth Taiwan Strait geopolitical crisis.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com 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

In lieu of next week’s report, I will be presenting a webcast titled ‘The 5 Big Mispricings In The Markets Right Now, And How To Profit From Them’. I do hope you can join. Executive Summary Just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes are setting in train a global recession. Demand is already cool, so aggressive rate hikes will take it to outright cold. The risk is elevated because central banks are desperate to repair their damaged credibility on fighting inflation, and it may be their last chance. Inflationary fears and hawkishness from central banks are weighing on bonds and stocks, and it may take some weeks, or months, for inflation fears to recede. But we could be approaching a turning point. By the summer, core inflation should be receding. Furthermore, the fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility that have signalled inflection points. Fractal trading watchlist: 30-year T-bond, NASDAQ, FTSE 100 versus Euro Stoxx 50, Netherlands versus Switzerland, and Petcare (PAWZ). US Inflation Is Hot, But Demand Is Not US Inflation Is Hot, But Demand Is Not US Inflation Is Hot, But Demand Is Not Bottom Line: Tactically cautious, but long-term investors who do not need to time the market bottom should overweight bonds and overweight long-duration defensive equities versus short-duration cyclical equities – for example, overweight US versus non-US equities. Feature The First World War, the historian AJP Taylor famously argued, was “imposed on the statesmen of Europe by railway timetables.” Taylor proposed that the railways and their timetables were so central to troop mobilisation – and specifically, the German Schlieffen Plan – that a plan once set in motion could not be stopped. “Once started the wagons and carriages must roll remorselessly and inevitably to their predestined goal.” Otherwise, the whole process would unravel, and an opportunity to demonstrate military credibility would be lost that might never come again. Today, could a global recession be imposed upon us by central bank timetables for aggressive rate hikes? Just as it was difficult to unwind the troop mobilisation that led to the Great War, it will be difficult to back down from the aggressive rate hikes that the central banks have timetabled, at least in the near term. Otherwise, an opportunity to demonstrate inflation fighting credibility would be lost that might never come again.  Just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes may set in train  another global recession. Unfortunately, central banks do not have precision weapons. Quite the contrary, monetary tightening is a blunt instrument which works by cooling overall demand. But demand is already cool, as evidenced by the contraction of the US economy in the first quarter. In their zeal to repair their damaged credibility on fighting inflation, the danger is that central banks take the economy from cool to outright cold. Granted, the US economy was dragged down by a drop in inventories and net exports. But even US domestic demand – which strips out inventories and net exports – is barely on its pre-pandemic trend (Chart I-1). Meanwhile, the euro area economy is still 5 percent below its pre-pandemic trend (Chart I-2). To reiterate, by hiking rates aggressively into economies that are at best lukewarm, central banks are risking an outright recession. Chart I-1US Inflation Is Hot, But Demand Is Not US Inflation Is Hot, But Demand Is Not US Inflation Is Hot, But Demand Is Not Chart I-2Euro Area Inflation Is Hot, But Demand Is Not Euro Area Inflation Is Hot, But Demand Is Not Euro Area Inflation Is Hot, But Demand Is Not Our Three-Point Checklist For A Recession Has Three Ticks My colleague Peter Berezin has created a three-point checklist for a recession: The build-up of an imbalance makes the economy vulnerable to downturn. A catalyst exposes this imbalance. Amplifiers exacerbate the downturn. Is there a major imbalance? You bet there is. The post-pandemic 26 percent overspend on durable goods in the US constitutes one of the greatest imbalances in economic history. Other advanced economies also experienced unprecedented binges on durable goods. The catalyst that is exposing this major imbalance is the realisation that durable goods are, well, durable. So, if you overspent on durables in 2020/21, then the risk is that you symmetrically underspend in 2022/23 (Chart I-3). The post-pandemic 26 percent overspend on durable goods in the US constitutes one of the greatest imbalances in economic history. Meanwhile, a future underspend on goods cannot be countered by an overspend on services because the consumption of services is constrained by time, opportunity, and biology. There is a limit to how often you can eat out, go to the movies, or go to the doctor (Chart I-4). Indeed, for certain services, an underspend will persist, because we have made some permanent post-pandemic changes to our lifestyles: for example, hybrid office/home working and more online shopping and online medical care. Chart I-3An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... An Overspend On Goods Can Be Corrected By A Subsequent Underspend... Chart I-4...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend ...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend Finally, the amplifier that will exacerbate the downturn is monetary tightening. If central banks follow their railway timetables for aggressive rate hikes, a goods downturn will magnify into an outright recession. So, in Peter’s three-point checklist, we now have tick, tick, and tick. Inflation Is Hot, But Demand Is Not If economic demand is at best lukewarm, then what caused the post-pandemic inflation that central banks are now fighting? The simple answer is massive fiscal stimulus combined with the equally massive shift in spending to durable goods. Locked at home and flush with government supplied cash, we couldn’t spend it on services, so we spent it on goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. For example, airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The causality from stimulus payments to durable goods spending to core inflation is irrefutable. The causality from stimulus payments to durable goods spending to core inflation is irrefutable. The biggest surges in US durable goods spending all coincided with the government’s stimulus checks (Chart I-5). And the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-6). As further proof, core inflation is highest in those economies where the stimulus checks and furlough schemes were the most generous – like the US and the UK. Chart I-5Stimulus Checks Caused The Surges in Durable Goods Spending Stimulus Checks Caused The Surges in Durable Goods Spending Stimulus Checks Caused The Surges in Durable Goods Spending Chart I-6The Surges In Durable Goods Spending Caused The Surges In Core Inflation The Surges In Durable Goods Spending Caused The Surges In Core Inflation The Surges In Durable Goods Spending Caused The Surges In Core Inflation What Does All This Mean For Investment Strategy? Our high conviction view is that the pandemic’s inflationary impulse combined with the Ukraine war will turn out to be demand-destructive, and thereby ultimately morph into a deflationary impulse. Yet central banks are all pumped up to demonstrate their inflation fighting credibility. Given that this credibility is badly damaged, it may be their last opportunity to repair it before it is shattered forever. To repeat, just as the railway timetables set in train the First World War, central bank timetables for aggressive rate hikes may set in train another global recession. That said, a recession is not inevitable. The interest rate that matters most for the economy and the markets is not the policy rate that central banks want to hike aggressively, it is the long-duration bond yield. A lower bond yield can underpin both the economy and the financial markets, just as it did during the pandemic in 2020. But to the extent that the bond market is following the real economic data, we are in a dangerous phase. Because, as is typical at an inflection point, the real data will be noisy and ambiguous. Meaning it may take some weeks, or months, for inflation fears to be trumped by growth fears. On March 10th, in Are We In A Slow-Motion Crash? we predicted:  “On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally” That prediction proved to be spot on! Recession, or no recession, we are still in a difficult period for markets because inflationary fears and hawkishness from central banks are weighing on bonds and stocks, while buoying the US dollar. As such, tactical caution is still warranted. Fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility. But we could be approaching a turning point. By the summer, core inflation should be receding. Furthermore, the fractal structures of the sell-offs in both the 30-year T-bond and the tech-heavy NASDAQ index are approaching points of extreme fragility that have reliably signalled previous inflection points (Chart I-7 and Chart I-8). Chart I-7The 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 I-8The 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 The advice for long-term investors who do not need to time the market bottom is: Bonds will ultimately rally. Overweight the 30-year T-bond and the 30-year Chinese bond. Equities will be conflicted between slowing growth which will weigh on cyclical profits, and falling bond yields which will buoy long-duration valuations.  Therefore, overweight long-duration defensive sectors and markets versus short-duration cyclical sectors and markets. For example, overweight US versus non-US equities. Fractal Trading Watchlist As just discussed, the sell-offs in the 30-year T-bond and the NASDAQ are approaching points of fractal fragility that have signalled previous turning points. Hence, we are adding both investments to our watchlist. Also added to our watchlist is the outperformance of the FTSE100 versus Euro Stoxx 50, and the underperformance of Netherlands versus Switzerland, both of which are approaching potential reversals. Our final addition is Petcare (PAWZ). After a stellar 2020, Petcare gave back most of its gains in 2021. But this underperformance is now approaching a point of fragility which might provide a new entry point. There are no new trades this week, but the full watchlist of investments at, or approaching, turning points is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 1The 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 2The 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 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 5Canada'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 6US 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 7A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 14The 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 15The 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 16Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 17US Homebuilders' Underperformance Has Reached A Potential Turning Point US Homebuilders' Underperformance Has Reached A Potential Turning Point US Homebuilders' Underperformance Has Reached A Potential Turning Point Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 20The 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 21A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Central Bank ‘Railway Timetables’ Are Dragging Us Into Recession Central Bank ‘Railway Timetables’ Are Dragging Us Into Recession Central Bank ‘Railway Timetables’ Are Dragging Us Into Recession Central Bank ‘Railway Timetables’ Are Dragging Us Into Recession 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  

Executive Summary A True Bond Bear Market, USD-Hedged Or Unhedged A True Bond Bear Market, USD-Hedged Or Unhedged A True Bond Bear Market, USD-Hedged Or Unhedged The US dollar has appreciated in 2022, most notably against the euro and Japanese yen. The rally has been more muted against the currencies of major US trading partners like the Canadian dollar and Chinese yuan. The dollar strength to date has had minimal impact on US inflation and will not force any adjustment in the Fed’s hawkish path on interest rates. The weakness of the euro and yen versus the USD will not turn the ECB or Bank of Japan more hawkish, given the lack of visible pass-through from currency depreciation to domestic inflation in Europe and Japan. The two largest owners of US Treasuries, China and Japan, have not increased Treasury purchases in response to higher US yields and a firmer US dollar. Geopolitical tensions and a desire to diversify out of US assets will continue to limit China buying of US Treasuries. Even higher US yields will be needed to compensate Japanese investors for higher bond and currency volatility at a time when the cost to hedge USD exposure is high and rising. Bottom Line: An appreciating US dollar is not yet a reason to expect a peak in US inflation or Treasury yields, or a change in ECB/BoJ policy. Maintain a neutral global duration stance and continue to underweight US Treasuries versus German Bunds and JGBs. Feature The strengthening US dollar (USD) has gotten the attention of investors, with the DXY index up +8.1% since the start of 2022 and threatening a major breakout from the range that has prevailed since 2016 (Chart 1). There have been notable moves in the major currencies that are in the DXY index, especially the euro (EUR) and Japanese yen (JPY). EUR/USD now sits at 1.05 and is threatening a move towards the parity level last seen in 2002. USD/JPY has seen a stunningly rapid increase to the current 130 level, rising 15 big figures in just two months. On a broader basis, the USD rally has been less impressive. The Federal Reserve’s nominal broad trade-weighted dollar index is up a more modest +3.7%  year-to-date (Chart 2). Currencies of the major US trading partners have seen less impressive moves versus the dollar compared to the euro and yen. The Canadian dollar is down -1.9%, while the Mexican peso is flat, versus the dollar so far in 2022. Even the tightly managed Chinese currency (CNY) has belatedly joined the depreciation party, with USD/CNY up +4% since mid-April. Chart 1USD Breaking Out Against The Majors USD Breaking Out Against The Majors USD Breaking Out Against The Majors ​​​​​ Chart 2Smaller FX Moves From The Larger US Trade Partners Smaller FX Moves From The Larger US Trade Partners Smaller FX Moves From The Larger US Trade Partners ​​​​​​ For bond markets, the move towards a stronger US dollar is relevant if a) it is sustainable; b) it helps cool off the overheating US economy; and c) it induces capital flows into US Treasuries. On all three counts, the current bout of dollar strength has not been enough to reverse the upward trajectory of US Treasury yields, in absolute terms and relative to government bonds in Europe and Japan. Multiple Drivers Of The USD Rally First and foremost, the latest appreciation of the USD has been about rising US interest rate expectations. The Fed’s increasingly hawkish rhetoric in response to surging inflation has forced a sharp upward adjustment of both the near-term and medium-term path for US bond yields. This has been most evident in the real yield component of yields, with the yield on the 10-year inflation-protected TIPS now in positive territory at +0.15% - a big increase from the -0.5 to -1% range that has prevailed during the past two years of the COVID pandemic. Related Report  Global Fixed Income StrategyWe’re All Yield Chasers Now The momentum of the USD rally, with a +13.6% year-over-year gain in the DXY index, has been robust compared to the outright level of US bond yield spreads versus the major developed markets, especially after adjusting for realized inflation differentials (Chart 3). This reflects other USD-bullish factors beyond US interest rate expectations. The US dollar typically behaves as a defensive currency, appreciating during periods of slowing global growth and/or rising investor risk aversion. Both are happening at the same time right now, boosting the safe haven appeal of the US dollar. Global growth expectations are depressed, with the ZEW survey of investment professionals back down to the pandemic lows of 2020 (Chart 4, top panel).1 Worries about slowing growth and high inflation, and the rapid tightening of global monetary policies needed to combat that inflation, are also weighing on investor confidence. US equity market volatility has picked up and investors are paying up to protect their portfolios via options - the VIX index is back above 30 and the CBOE put/call ratio is at a two-year high (middle panel). Chart 3A Big USD Rally Fueled By Wider Real Yield Differentials A Big USD Rally Fueled By Wider Real Yield Differentials A Big USD Rally Fueled By Wider Real Yield Differentials ​​​​​​ Chart 4Slowing Global Growth & Rising Risk Aversion Weighing On USD Slowing Global Growth & Rising Risk Aversion Weighing On USD Slowing Global Growth & Rising Risk Aversion Weighing On USD ​​​​​​ This “perfect storm” of USD-bullish factors – rising US interest rate expectations, slowing global growth expectations and increased investor nervousness – has pushed to USD to a level that now appears stretched. BCA Research’s US Dollar Composite Technical Indicator, which combines measures of breadth, momentum, sentiment and trader positioning, is now at an overbought extreme that has heralded past US dollar reversals (bottom panel). Bottom Line: The rising US dollar now discounts a lot of Fed tightening, growth pessimism and investor fear. Conditions for a reversal are in place if any of those USD-bullish factors lose influence, most notably Fed expectations. USD Strength Does Not Impact The Outlook For The Fed, ECB Or BoJ Chart 5A True Bond Bear Market, USD-Hedged Or Unhedged A True Bond Bear Market, USD-Hedged Or Unhedged A True Bond Bear Market, USD-Hedged Or Unhedged USD strength has made life even more difficult of bond investors, at a time when returns across the fixed income universe have suffered because of the duration-related losses from rising bond yields. The Bloomberg Global Treasury index is down -12.2% so far in 2022, and down -18% from the 2020 peak, on a currency-unhedged basis (Chart 5). The returns are not much better this year on a USD-hedged basis, down -6.8% since the start of the year. The latter is suffering from both duration losses and the rising cost to hedge the US dollar. An investor hedging USD exposure into JPY must pay an annualized 165bps (using 3-month currency forwards), while hedging USD exposure into EUR costs 200bps. Those hedging costs primarily reflect higher US interest rate expectations versus Europe and Japan. They will only come down when markets believe that the Fed will stop raising interest rates and begin to easy policy. It is not clear that the current bout of USD strength, on its own, is enough to change the Fed’s plans. Typically, a substantially stronger US dollar would lead the Fed along a less hawkish path, as it would act to slow imported inflation pressures. However, this is not a typical Fed cycle with US headline CPI inflation at a 41-year high of 8.5%. A huge part of that US inflation overshoot is due to global supply squeezes that have impacted the prices of traded goods and commodities. On a rate-of-change basis, the appreciating US dollar is coinciding with some slowing of commodity price momentum, but less so for goods prices. The index of world export prices compiled by the CPB Research Bureau in the Netherlands is up +12.2% on a year-over-year basis, a rapid pace that typically exists during periods of US dollar depreciation (Chart 6, top panel). The annual growth of the CRB commodity index is +17.2%, down from the peak of +54.4% in June 2021, and has roughly tracked the acceleration of the US dollar (middle panel). Yet even with the moderation of commodity inflation, the US dollar strength seen to date has not been enough to slow overshooting global goods price inflation – a necessary condition for central banks like the Fed to turn less hawkish (bottom panel). We do expect global goods price inflation to moderate over the rest of 2022, especially in the US, as post-pandemic consumer spending patterns shift away from goods back towards services. This will be a demand-related story, however, not a USD-strength-related story. Until there is more decisive evidence that goods inflation is slowing meaningfully, the Fed will be forced to deliver on its latest hawkish rhetoric. This includes shifting to a path of hiking rates by 50bps per meeting and moving towards a faster reduction of the Fed’s balance sheet. Right now, there is not much evidence suggesting that the stronger dollar should derail that trajectory (Chart 7): Chart 6USD Strength Not Helping To Slow Global Inflation USD Strength Not Helping To Slow Global Inflation USD Strength Not Helping To Slow Global Inflation ​​​​​ Chart 7The Fed Will Remain Hawkish, Despite A Firmer USD The Fed Will Remain Hawkish, Despite A Firmer USD The Fed Will Remain Hawkish, Despite A Firmer USD ​​​​​​ Non-oil import prices are expanding at a +7.5% pace and accelerating in the face of a firmer US dollar that would normally coincide with slowing import price growth (top panel) The overall level of US financial conditions – which includes not only the currency but other variables like equity prices and corporate bond yields - remains stimulative, both in absolute terms and relative to the level of the trade-weighted US dollar (middle panel). One area of concern is the widening US trade deficit, now nearly -5% of GDP in nominal terms (bottom panel). That wider deficit is primarily related to the combination of strong import demand (and soaring import prices) and soft export demand given slowing global growth. A stronger US dollar does not help reverse either of those trends. However, it is difficult for the Fed to isolate the impact of the currency on the trade deficit given the other non-currency-related factors weighing on US export and import demand (i.e. weaker exports because of the Ukraine war and China COVID lockdowns). In sum, the US dollar strength seen so far does not change our expectations on the path of US inflation, and the pace of Fed tightening, over the next 6-12 months. We still see the Fed delivering multiple rate hikes, but less than the 298bps discounted in the US overnight index swap (OIS) curve over the next year. Conversely, the weakness of the euro and yen versus the US dollar does not change our outlook for the ECB and Bank of Japan. We see both central banks not delivering anything close to the rate hikes discounted in OIS curves. Chart 8Not Much Inflation From A Weaker Euro & Yen Not Much Inflation From A Weaker Euro & Yen Not Much Inflation From A Weaker Euro & Yen On a trade-weighted basis, the euro is only down -5% over the past year - a modest move in comparison to soaring euro area inflation, which hit +7.5% on a headline basis and +3.5% on a core basis in April (Chart 8, middle panel). The ECB is under pressure to end its asset purchases very quickly and begin raising rates, but the euro does not appear to be a reason to accelerate the ECB’s timetable. In Japan, the very rapid weakening of the yen has generated shockingly little inflation, especially in the current environment of strong global goods/commodities inflation. The trade-weighted yen is down -12.7% on a year-over-year basis, yet Japan’s “core-core” CPI index that excludes food and energy prices remains in deflation hitting -0.7% in March – a move exaggerated by plunging mobile phone prices, but still very weak compared to the path of the yen and global goods prices. OIS curves are currently discounting 183bps of ECB rate hikes and 9bps of Bank of Japan rate hikes over the next year. We recommend fading that pricing by staying overweight core Europe and Japan in global bond portfolios, especially versus the US where the Fed is far more likely to follow through on discounted rate hikes. Bottom Line: The dollar strength to date has had minimal impact on US inflation and will not force any adjustment in the Fed’s hawkish path on interest rates. At the same time, the weakness of the euro and yen versus the USD will not turn the ECB or Bank of Japan more hawkish, given the lack of visible pass-through from currency depreciation to domestic inflation in Europe and Japan. Can Foreign Investors Replace Fed Treasury Buying? Chart 9UST Demand Shifting To More Price-Sensitive Buyers UST Demand Shifting To More Price-Sensitive Buyers UST Demand Shifting To More Price-Sensitive Buyers For bond investors, the role of non-US demand for US Treasuries has always been a source of mystery that is often used to explain yield movements. Rumors of flows from major emerging market currency reserve managers or large Asian pension funds has often been used to justify a bullish or bearish view on Treasuries – even when hard data that could prove the existence of such flows is published with long lags that make it useless for timely analysis. The impact of potential foreign bond buying on US Treasury yields has been less influential over the past couple of years. Fed buying via quantitative easing (QE) has swamped all other sources of demand for Treasuries. With the Fed now in a rate hiking cycle that will also lead to a rapid start of quantitative tightening (QT) this summer, the question of who will replace the Fed’s demand for US Treasuries becomes once again relevant for the future path of US bond yields beyond the expected path of the fed funds rate. Already, there has been an adjustment in the term premium for longer-term US Treasury yields – the component of bond yield valuation that would be most impacted by large flows - as the Fed has slowed its pace of bond buying (Chart 9). The New York Fed’s estimates of the term premium on the 10-year Treasury yield reached deeply depressed levels – around -100bps - at the peak of the Fed’s pandemic QE program in 2020. As the US economy has recovered from the 2020 COVID recession, US interest rate expectations have increased but so have estimates of the term premium, which are now back to zero or even slightly positive. The Fed’s QE bond buying has been purely volume driven, with the size and timing of the purchases announced well in advance. The Fed is often called a “price insensitive” buyer since its buying is done without any consideration of yield levels. Other Treasury investors, including foreign buyers, are more price sensitive, with demand influenced by the level of yields. According to the TIC database on US capital flows produced by the US Treasury Department, net foreign buying of Treasuries has picked up, totaling +$346 billion over the 12 months to the most recently available data from February 2022 (Chart 10). That increase has entirely come from private investors, as so-called “official” flows have been flat. Chart 10China Remains On A UST Buyer's Strike China Remains On A UST Buyer's Strike China Remains On A UST Buyer's Strike ​​​​​​ Chart 11European Buying Of USTs Set To Peak? European Buying Of USTs Set To Peak? European Buying Of USTs Set To Peak? ​​​​​​ The latter is a continuation of the trend seen over the past few years where China, the nation with the second largest holdings of US Treasuries, has stopped buying them. This is a decision rooted in both geopolitics and economics. Smaller trade surpluses mean China has fewer new currency reserves to invest, while worsening Sino-US tensions have led Chinese authorities to diversify existing reserve holdings away from US Treasuries into gold and other assets. Looking ahead, China is unlikely to significantly ramp up its Treasury purchases despite more attractive US yields and Chinese policymakers tolerating some mild currency weakness versus the US dollar. Beyond China, demand for Treasuries from Europe and Japan has picked up but remains moderate by historical standards. For European investors, there has been a major swing in the TIC data, moving from a net outflow (on a 12-month running total basis) of -$194 billion in December 2020 to a net inflow of +$24 billion in February 2022 (Chart 11, top panel). Typically, net inflows into Treasuries are linked to the FX-hedged spread between US and German government debt. Specifically, when the hedged 10-year Treasury-Bund spread widens to a level between 100-150bps, the flows from Europe into Treasuries begin to improve (middle panel) When that hedged spread narrows to zero or lower, the flows turn the other way and European demand for Treasuries begins to wane. That is typically followed by a widening of the unhedged Treasury-Bund spread (bottom panel). With the current FX-hedged Treasury-Bund spread now at zero, a result of the high cost of hedging US dollars into euros given elevated US rate expectations, we expect European demand for Treasuries to diminish over the rest of 2022. This will help support a wider Treasury-Bund spread as the Fed delivers far more rate hikes than the ECB. For Japan, the largest holder of Treasuries, there has only been a stabilization of outflows over the 12 months to February 2022 (Chart 12, top panel). Past periods of large net inflows from Japan into US Treasuries have occurred when the hedged 10-year US Treasury-JGB spread has approached 200bps (middle panel). With the current spread at only 112bps, Japanese investor demand for Treasuries is unlikely to return without a significant increase in US yields. Chart 12UST Yields Not Attractive Enough To Induce More Japanese Demand UST Yields Not Attractive Enough To Induce More Japanese Demand UST Yields Not Attractive Enough To Induce More Japanese Demand ​​​​​​ Chart 13Foreign Bond Investing Is Too Volatile For Japanese Investors Right Now Foreign Bond Investing Is Too Volatile For Japanese Investors Right Now Foreign Bond Investing Is Too Volatile For Japanese Investors Right Now More timely weekly capital flow data from Japan shows that Japanese investors have been reluctant to move money into foreign bonds (Chart 13). Elevated levels of bond/rate volatility, and currency volatility given the huge rally in USD/JPY, have made large Japanese bond investors more cautious on increasing foreign bond allocations, even on a currency-hedged basis. If bond/FX volatility subsides, Japanese investors will become “better buyers” of foreign bonds once again. However, Japanese investors may opt to increase allocations to European bonds rather than US Treasuries, with European yields at comparable levels to US Treasuries in JPY-hedged terms (Tables 1-4). For example, a 30-year German Bund hedged into yen now yields 1.46%, compared to a JPY-hedged 30-year US Treasury yield of 1.33%. Table 12-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish Table 25-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish Table 310-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish Table 430-Year Developed Market Government Bond Yields, Hedged Into USD, EUR & JPY Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish Bottom Line: Foreign demand for US Treasuries is unlikely to accelerate enough to replace diminished Fed QE purchases over the next 6-12 months, given high USD-hedging costs and elevated Treasury yield volatility. Non-US investors will not help bring an end to the US bond bear market. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The Global ZEW expectations series shown in Chart 4 is an equal-weighted average of the individual expectations series for the US and euro area. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Recent USD Strength Is Not Bond Bullish Recent USD Strength Is Not Bond Bullish Tactical Overlay Trades

Listen to a short summary of this report.         Executive Summary The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The number of births collapsed during the pandemic. While the preliminary evidence suggests that fertility rates are starting to recover in most developed economies, they remain well below the level necessary to maintain a stable population. Aging populations are putting strain on pension and health care systems. They are also threatening to undermine geopolitical influence. The conventional wisdom is that there is not much that can be done to lift fertility rates. While it is true that government subsidies to encourage parents to have more children are not especially effective, other policies, such as cheaper child care, are more promising. Rather than discouraging property investment, China is likely to increase housing supply in order to make family formation more affordable. This could boost commodity demand. More contentiously, the use of IVF technologies to select for certain traits such as higher intelligence in children could open up a new front on the geopolitical battlefield that few analysts are expecting. Regardless of government policy, birth rates will eventually rise of their own accord because both cultural and genetic evolution will select for families that wish to have more children. In the long run, faster population growth will lead to stronger corporate sales, which is a plus for equities. Over a shorter-term horizon, however, the global dependency ratio could end up increasing, as the number of retirees rises while the number of children that parents need to support goes up. This could put upward pressure on interest rates and bond yields. Bottom Line: Contrary to popular opinion, global fertility rates may be bottoming and could rise significantly over the long run. While this trend will eventually benefit stocks, it is likely to come at the expense of higher bond yields.    Dear Client, We tactically downgraded global equities from overweight to neutral on February 28th. As we discussed last week in our report entitled “Here Comes Goldilocks,” we see a more fortuitous environment emerging in the second half of the year, which suggests that stocks will likely be higher over a 12-month horizon. This week, we step back from recent market action to focus on a long-term investment theme of great importance: demographic change. Contrary to the conventional wisdom that sees birth rates continuing to fall over the next few decades, we argue that developed economies may be on the cusp of a strong and sustained baby boom.  I will be visiting clients in the San Francisco Bay Area next week. Instead of our regular report, we will be sending you a Special Report written by Irene Tunkel, BCA’s Chief US Equity Strategist. Irene will discuss inflation regimes and their implications for US equities. Best regards, Peter Berezin, Chief Global Strategist Baby Bust At the start of the pandemic, some speculated that with little else to do, couples would spend more time in bed, leading to a mini baby boom. As it turned out, the exact opposite happened: Birth rates plunged around the world. In the US, the number of babies born in January 2021 was about 10% lower than one would have expected based on the pre-pandemic trend. Similar shortfalls were observed in the UK, France, Italy, Spain, and Japan (Chart 1). In China, the number of births fell by almost 30% between 2019 and 2021 to the lowest level since 1949 (Chart 2). Chart 1The Birth Rate Has Recovered Since The Start Of The Pandemic But Remains Below Levels Consistent With A Stable Population The Coming Stork Wars The Coming Stork Wars Chart 2The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 While the pandemic continues to restrain fertility in China, the latest data from developed economies suggest births have rebounded. Nevertheless, birth rates remain far below the level necessary to maintain stable populations. A recent study in The Lancet estimated that more than three-quarters of countries would have below-replacement fertility rates by the end of the century. The study estimated that the global population would peak at 9.7 billion in 2064 and decline to 8.8 billion by 2100. Alarm Over Low Birth Rates Low birth rates have become a major cause of concern for policymakers. Aging populations are putting strain on pension and health care systems. The OECD expects the old-age dependency ratio to double from 30% to 60% by 2075 (Chart 3). Pension spending in the OECD is projected to rise by 1.4% of GDP over the next 40 years. Chart 3Conventional Forecasts Expect The Population To Grey Over The Coming Decade The Coming Stork Wars The Coming Stork Wars Chart 4The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century Health care spending is likely to grow at an even faster pace. In the US, the Congressional Budget Office sees federal government-financed health care spending rising from 5.7% of GDP to 9.4% of GDP by 2050. As has been the case in Japan and Russia, and could be the case in China, a shrinking population threatens to undermine geopolitical influence. The UN estimates that China’s working-age population will decline from about 1 billion to less than 600 million by the end of the century. By 2100, Nigeria’s working-age population is projected to approach China’s (Chart 4). It is difficult to be an economic and military superpower if you do not have enough workers and soldiers.   Pro-Natal Subsidies: Little Bang for the Buck Governments are responding by adopting increasingly aggressive pro-natal policies. According to the UN, more than 50 countries have officially declared their intention to increase fertility rates (Chart 5). Chart 5Governments Are Actively Trying To Raise Fertility Rates The Coming Stork Wars The Coming Stork Wars Chart 6Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Various European countries, ranging from Estonia, Germany, Greece, Finland, France, Italy, and Lithuania to the UK offer varying bonus payments to new parents. Japan and Singapore both have baby bonus schemes. South Korea, which has the lowest fertility rate in the world, recently increased the reward it pays to mothers from US$500 to US$1,700. The most significant pro-natal shift has come from China. After having officially abandoned its one-child policy in 2016, China announced last year that it will allow couples to have up to three children. We expect China to introduce generous subsidies to encourage childbirth over the next few years. Will such policies arrest the decline in birth rates? There are certainly reasons to be skeptical. Chart 6 shows that spending on family benefits in OECD economies rose from 1.5% to 2.1% of GDP over the past 40 years. Yet, the fertility rate fell from 2.25 to 1.66 over this period. Can Anything Turn the Tide? A number of structural forces have contributed to lower fertility rates. These include increased female labor market participation, readily available birth control, falling child mortality, and rising housing and educational costs. The availability of government-provided income support and health care has also arguably reduced the historic role that children have played in supporting their parents in old age. The conventional wisdom is that these forces will only strengthen in the future, ensuring that fertility rates keep dropping. I am not so sure. Are Children Inferior, Normal, or Veblen goods? While it is rather awkward to think of the decision to have children in economic terms, there is some logic to this approach. Economists tend to distinguish between substitution and income effects. The substitution effect for children is negative: As wages rise, the opportunity cost of having children goes up. In contrast, a number of studies have documented that the income effect is positive: Give a couple an extra $1 million, no strings attached, and that could push them over the line in deciding to have an additional child (in economic parlance, children are “normal” rather than “inferior”). Economists have long known that labor supply curves tend to be “backward bending” (Charts 7A & B). The classic example is that of leisure. As wages initially rise from low levels, people may seek to work more (and hence, consume less leisure). Eventually, however, if wages rise enough, people will cut back on work in order to enjoy the fruits of their labor. Chart 7ABackward-Bending Demand Curves May Also Apply To Children The Coming Stork Wars The Coming Stork Wars Chart 7BLower Child-Rearing Costs Would Improve The Demographic Problem The Coming Stork Wars The Coming Stork Wars The same sort of backward-bending demand curve may apply to children. As wages rise above a certain threshold, parents may decide that they can afford to have more children. Chart 8 shows that the correlation between per capita income and realized fertility has turned positive in developed economies. Chart 8Correlation Between Incomes And Realized Fertility Has Turned Positive In Developed Countries The Coming Stork Wars The Coming Stork Wars Looking out, it is possible that children will become “Veblen” goods, named after nineteenth-century economist Thorstein Veblen, who coined the term “conspicuous consumption.” With many luxury goods now available to the masses, what better way to signal that one has made it to the top than to have five kids in Manhattan or Beverly Hills? How Expensive Are Children, Really? Across most developed economies, women tend to end up having fewer children than they would like (Chart 9). While difficulty in finding a suitable spouse is sometimes cited as a reason, the financial hardship associated with parenting usually ranks higher. Chart 9Most Women Are Having Fewer Children Than They Desire The Coming Stork Wars The Coming Stork Wars Chart 10Depression Rates Among Children And Teenagers Have Been Increasing Over The Past Decade The Coming Stork Wars The Coming Stork Wars According to one recent estimate, it costs nearly $300,000, excluding college tuition, to raise a child in the US. This number, however, is conditional on what society currently deems appropriate for rearing children. If the incremental cost of a child were to decline, the slope of the budget constraint in Chart 7B would become flatter, implying that both the income and substitution effects would reinforce each other in the direction of having more children. Could society eventually conclude that the cost of having a child is not as large as widely perceived? The idea is not as far-fetched as it sounds. Having turned 50 this week, I find it interesting to look back at how much cultural norms towards kids have changed over the past few decades. Growing up in Hamilton Ontario, I remember taking the public bus alone at the age of 10 to school, the pool, or anywhere else I wanted to go. Are kids even allowed to leave the house unattended anymore? As Derek Thompson points out in a recent article in The Atlantic, American parents have nearly doubled the amount of time spent raising their kids. And what has the advent of helicopter parenting achieved? It is difficult to point to any concrete benefits. Depression rates among children and teenagers have soared (Chart 10). While the proliferation of social media has exacerbated childhood angst, the tendency for parents to try to shield their children from hardship and failure has probably only made things worse. Does Schooling Matter Much? Sticking with the issue of schooling, to what extent does the modern parental preoccupation with education actually benefit children? Probably a lot less than parents realize. IQ is highly correlated with educational achievement and many other favorable life outcomes (Chart 11). IQ scores are by far the best predictors of job performance, much better than fashionable concepts such as “emotional intelligence” (Chart 12). Chart 11IQ Tests Don’t Just Measure How Well You Can Do On An IQ Test The Coming Stork Wars The Coming Stork Wars Chart 12Cognitive Ability Matters A Lot For Job Performance The Coming Stork Wars The Coming Stork Wars In healthy, well-nourished populations, genetics explains about 50% of IQ variation at age ten and 80% in adulthood (Chart 13). In fact, IQ is almost as heritable as height (Chart 14). Chart 13The Heritability Of IQ Reaches 80% By Adulthood The Coming Stork Wars The Coming Stork Wars Chart 14IQ Is Almost As Heritable As Height The Coming Stork Wars The Coming Stork Wars When a child suffers from economic or social deprivation, improvements to their environment can have a large positive impact on their cognitive performance. However, beyond a certain environmental threshold, there is not much that parents can do. A recent study concluded that “there is only a marginal and inconsistent influence of parenting on offspring IQ in adolescence and young adulthood.” Table 1A Poisoned Chalice? Genetic Screening Can Raise IQ The Coming Stork Wars The Coming Stork Wars Even musical training, which parents often spend a fortune on, does not appear to generate any knock-on benefits for math or language skills. As much as I hate to say it, the evidence suggests that the most reliable way to enhance a child’s educational prospects is to endow them with high IQ genes. I will not speak to the questionable ethics of doing so, but as I discussed in my report on the rise and fall of human intelligence a few years ago, the technology is coming. Carl Shulman and Nick Bostrom estimate that genetic screening could boost average IQs by up to 65 points in five generations (Table 1).   The Stork Wars The ability to engineer high-IQ children through IVF technologies could open up a front on the geopolitical battlefield that few analysts are expecting. Such a battlefield for geopolitical supremacy will take place at a time when China and Russia, on the one side, and much of the West, on the other side, are moving in polar opposite directions on a variety of cultural issues. The empirical evidence suggests that there is a U-shaped relationship between gender equality and fertility rates. Both patriarchal societies, such as those in parts of the Middle East, and egalitarian societies, such as those in Scandinavia, have been able to maintain relatively high fertility levels. Between these two extremes, fertility rates are typically well below replacement. Whereas most Western nationals have sought to promote gender equality in recent years, China and Russia have shifted in a more traditionalist direction. Last April, China’s government shut down a number of feminist social media groups. This followed a statement by China's Education Ministry that the government would seek to “cultivate masculinity.” Boys were becoming “delicate, timid and effeminate,” a key government advisor declared. Ironically, both the traditionalist and egalitarian approaches could lift fertility rates, but at the cost of an ever-wider cleavage in the global culture wars. The Long-Term Outlook for Fertility Rates: Up, Up, and Away? In a world of abundant material resources, a steady or declining population is not an evolutionary stable equilibrium. As long as there are some selection pressures towards having more offspring, in the absence of offsetting forces, evolution will push up fertility rates.  In the pre-industrial era, parents with many children often struggled to keep enough food on the table. The correlation between parent and child fertility was close to zero, meaning that children who came from big families did not have more surviving offspring than children from small families. After the Industrial Revolution, the correlation turned positive, and by most indications, has been rising over the past few decades. Were it not for the positive correlation between parent and child fertility, global population levels would be even lower today. How high could birth rates climb if the cultural forces, which have suppressed fertility over the past century, abate? The natural tendency is to think that evolution works too slowly to matter. However, this represents a misreading of the evidence. When there are evolutionary disequilibria – that is, when the environment changes in ways that renders existing reproductivity strategies suboptimal – natural selection can work surprisingly fast. Contrary to the widespread notion that human evolution stopped before the Agricultural Revolution, a recent study in Nature found that 88% of physiological traits have undergone polygenic change during the past 2,000 to 3,000 years. Using plausible estimates of intergenerational fertility correlations, Jason Collins and Lionel Page calibrate a model of global population growth. In contrast to more conventional demographic models, they conclude that global population growth, rather than turning negative later this century, will accelerate. In their baseline model without any heritability effects, the global total fertility rate falls to 1.82 by the end of the century. Once heritability effects are included, the projected total fertility rate rises to 2.21 (Chart 15). The largest effects are for Europe and North America, the first two regions to undertake a demographic transition to (temporarily) low birth rates. The authors see the European median total fertility rate rising to 2.46 by the end of the century, with the North American rate increasing to 2.67. Chart 15Natural Selection Could End Up Boosting Fertility Rates Over The Long Run The Coming Stork Wars The Coming Stork Wars Notably, the support ratio – the ratio of workers-to-consumers – continues to fall in their model over the remainder of the century. They conclude: “Once the increase in number of children is taken into consideration, the higher number of children in the heritability model merely shifts the nature of the burden rather than ameliorating it.” Investment Conclusions The world is at a demographic inflection point. After rising steadily for four decades, the global support ratio has peaked (Chart 16). Baby boomers are beginning to leave the labor market en masse. While they were working, they accumulated a lot of assets. In the US, baby boomers hold more than half of all household wealth (Chart 17). Chart 16Less Workers And More Consumers Over The Next Decades Less Workers And More Consumers Over The Next Decades Less Workers And More Consumers Over The Next Decades Chart 17Baby Boomers Hold More Than Half Of Wealth In The US The Coming Stork Wars The Coming Stork Wars Going forward, rather than working and saving, baby boomers will spend down their wealth. The global pool of savings will shrink, putting upward pressure on equilibrium real interest rates and bond yields. Faced with the prospect of shrinking work forces, strained social security systems, and declining geopolitical influence, countries with low or negative population growth will offer increasingly generous subsidies to encourage couples to have more children. The resulting bigger budget deficits will further drain national savings. In and of themselves, government subsides are unlikely to significantly boost birth rates. More holistic policies will be needed, including steps to reduce the cost of child care and housing. Rather than discouraging property investment, China is likely to increase housing supply in order to make family formation more affordable. This could help support commodity demand.  Governments will try to influence the social and cultural narrative on family matters.In some cases, the impact could be quite innocuous, such as China’s decision to ban for-profit tutoring companies in order to ease pressure on students and parents. In other cases, the impact could be very contentious, leading to an escalation in the so-called culture wars. Regardless of the policy measures that governments adopt, birth rates will eventually rise of their own accord because both cultural and genetic evolution will select for families that wish to have more children. In the long run, faster population growth will lead to stronger corporate sales, which is a plus for equities. Over a shorter-term horizon, however, the global dependency ratio could end up increasing, as the number of retirees rises while the number of children that parents need to support goes up. On balance, therefore, we see demographic trends as being somewhat negative for stocks over the next one-or-two decades. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter View Matrix The Coming Stork Wars The Coming Stork Wars Special Trade Recommendations Current MacroQuant Model Scores The Coming Stork Wars The Coming Stork Wars

Dear Client, This week, we present our inaugural report on ESG investing and the global energy transition. Henceforth, we will be publishing this research on the last Thursday of every month. Our principal ESG focus will be on the Environmental aspects of climate change, and the policies and actions undertaken to arrest the rise in the Earth's temperature via decarbonization. To date, the goal of Environmental policy in many jurisdictions – e.g., the US and EU – has been to disincentivize exploration, production, refining and transportation investment in hydrocarbons. At the same time, it has strongly incentivized investment in renewable-power generation. This has produced volatile marginal effects, forcing commodity markets to allocate increasingly scarce energy and metals supplies against a backdrop of increasing demand. It is at this nexus where investment opportunities will emerge. ESG's Social and Governance pillars are slower-moving change agents, with long-duration effects. Human-rights failures can destroy lives and lead to social unrest. Failed corporate governance and national governance can sharply alter firms' abilities and willingness to invest in environmentally responsible resource development. Failure in both dimensions can profoundly affect commodity supply-demand balances, and imperil the energy transition. Much of what passes for ESG measurement and compliance is self-reported – when data are available – and differs little from PR or virtue signaling. This is starting to change. Over the next 2-3 years, we expect a continued increase in government involvement in standardizing ESG reporting – cf, the SEC's recent proposal for reporting Scope 1, 2 and 3 emissions, and an increased focus on carbon pricing, which we believe will require a global carbon tax or carbon-price floor. This will be needed to incentivize investment in renewables and carbon-reduction and -capture technology, given the near-impossibility of harmonizing local and regional carbon-trading schemes. Otherwise climate clubs – i.e., trading blocs comprising states with shared ESG goals – will emerge, which will further fragment global trade. We are hopeful you will find this research useful in your decision making and investing. Bob Ryan Managing Editor, Commodity & ESG Strategy Executive Summary Fossil Fuels Dominate Global Energy Mix Fossil Fuels Dominate Global Energy Mix Fossil Fuels Dominate Global Energy Mix Whether or not the SEC's proposal to disclose Scope 1, 2 and 3 emissions and other risk factors by firms it regulates will be adopted in whole or in part, we are confident it foreshadows deeper government involvement in the ESG arena in the near term in the US and EU. Carbon pricing will become increasingly important in global climate-change policy. We believe this will require a global carbon tax or carbon-price floor to incentivize investment in renewables and carbon-reduction and -capture technology. Failure to agree on at least a carbon price floor over the next 2-3 years almost surely will lead to the formation of climate clubs. In such clubs, like-minded states with similarly rigorous carbon-pricing and ESG disclosure requirements will allow trade among each other, but will levy tariffs against firms in states lacking such policies. Bottom Line: Governments are approaching a reckoning on their commitments to reduce or slow CO2 and greenhouse-gas (GHG) emissions. These are meant to hold the rise in the Earth's temperature to less than 2° C, or to approach the 1.5° C goal of the Paris Agreement. Reporting mandates like the EU's and the SEC's proposed CO2/GHG reports will help, as will increased subsidies and tax support for carbon-capture and hydrogen technology. However, a global carbon tax or carbon-price floor will be required to incentivize the investment needed to meet climate-change goals. Feature Voluntary programs and self-reporting are not reducing the concentration of CO2 and other GHGs fast enough to stay on track to meet Paris Agreement targets of holding the rise in the Earth's temperature to less than 2° C vs, pre-industrial levels, or preferably to 1.5° C. Over the next couple of years, we believe states will have to mandate additional ESG reporting – particularly on CO2 and other GHG emissions – and will require audits of programs and reports connected to GHG emissions, given the scope of what they are trying to accomplish. The EU got the ball rolling on reporting emissions, and now the US SEC is proposing new regulations as well. These will require the firms it regulates to disclose Scope 1, 2 and 3 emissions and other climate-related factors that constitute material risks to revenues and profits.1 Regardless of whether this proposal makes it through the legislative process, firms with operations in the EU will have to comply with similar reporting requirements if similar proposals are approved. Growing Energy Demand Fuels Higher CO2 Emissions World electricity demand – the principal focus of the global energy transition – grew 6% last year, on the back of strong GDP growth and weather-related demand. 2021 saw the highest electricity demand growth recorded by the IEA in the post-GFC recovery that began in 2010, amounting to 1,500 Twh year-on-year. Coal covered more than half of the growth in global electricity demand last year, and has constituted a major chunk of the electricity mix over a longer historical sample. Based on data starting in 2000, the world – primarily EM – has been net positive coal-fired power capacity (Chart 1) which reached an all-time high in 2021 as well, rising 9% y/y, while gas-fired generation grew 2%. The increase in fossil fuel generation pushed CO2 emissions globally up almost 6% to record highs. Renewable generation grew by 6% last year and is expected to meet most of the increase in electricity demand over the 2022-24 period with 8% p.a. growth, according to the IEA. Coal demand surged on the back of robust economic growth and weather-related factors, which helped propel global CO2 emissions to a record high at just over 36 billion MT in 2021, according to the IEA. This reversed the downturn in 2020 caused by the COVID-19 pandemic (Chart 2). Higher methane and nitrous oxide emissions, plus CO2 released by oil and gas flaring, lifted total energy-related GHG emissions to record levels last year as well. Chart 1Coal-Fired Power Has Been A Constant Looking Through ESG Virtue Signaling Looking Through ESG Virtue Signaling Chart 2Fossil Fuels Dominate Global Energy Mix Fossil Fuels Dominate Global Energy Mix Fossil Fuels Dominate Global Energy Mix We find evidence of a long-run relationship between real GDP and carbon dioxide emissions (Chart 3). This likely plays out through cointegration between oil consumption with real GDP, a relationship we exploit when estimating our monthly oil balances. While the income elasticity for emerging economies reliant on manufacturing – e.g., India and China – is positive, for the EU, a bloc of developed nations, that elasticity turns negative. This is consistent with the hypothesis of the Environmental Kuznets Curve, which states that initial increases in GDP per capita are associated with environmental degradation, however, beyond a point, income increases are associated with lower environmental damage.2 Interesting, as well, is the lack of any cointegration between GDP and US CO2 emissions. That may be due to the increased use of natgas vs. coal, and the fact that the energy intensity of US GDP continues to fall. Energy demand levels, including electricity, continues to exceed renewables supply. So even though renewable-energy generation growth is expected to meet 90% of energy demand growth from 2022 to 2024, the accumulation of CO2 and other GHGs will continue keeping the level of pollutants rising over that period. Chart 3CO2 Closely Tied To GDP CO2 Closely Tied To GDP CO2 Closely Tied To GDP   Recent research on global CO2 emissions growth for different countries based on historical values for population, GDP per capita and carbon intensity (measured as CO2 emissions per unit of GDP) projects median annual CO2 emissions in 2100 will be 34 Gigatons (Chart 4).3 This is significantly higher than the emissions required to keep temperature increases under 2° C by the end of the forecast period. The forecast is accompanied by four other CO2 emission scenarios provided by the Intergovernmental Panel on Climate Change (IPCC). Chart 4CO2 Projected Increases Overshoot Paris Agreement Targets Looking Through ESG Virtue Signaling Looking Through ESG Virtue Signaling Carbon Tax Needed One of our high-conviction views is governments worldwide need to agree a global carbon tax that can be applied directly to CO2 emissions.4 If a global carbon tax cannot be agreed, a global carbon-price floor also could be used to incentivize the investment needed to meet climate-change goals. An IMF analysis entitled "Five Things To Know About Carbon Pricing" published in September notes: "An international carbon price floor can be strikingly effective. A 2030 price floor of $75 a ton for advanced economies, $50 for high-income emerging market economies such as China, and $25 for lower-income emerging markets such as India would keep warming below 2°C with just six participants (Canada, China, European Union, India, United Kingdom, United States) and other G20 countries meeting their Paris pledges." There may be legitimate grounds for arguing over the point at which the tax is collected – i.e., at the production or consumption stages – but, in our view, this would be far superior (and quicker to implement) than trying to harmonize the different carbon-trading schemes worldwide. In addition, the revenues generated by the tax would allow governments to protect the interests of lower-income constituencies, which are most adversely affected by such regressive taxes. We also have maintained failure to agree a carbon tax of some form over the next 2-3 years almost surely will lead to the formation of climate clubs, a notion pioneered by William Nordhaus, the 2018 Nobel Laurate.5 In Nordhaus's clubs, like-minded states with similarly rigorous carbon-pricing and ESG disclosure requirements will allow trade among each other, but will levy tariffs against firms in states lacking such measures. There is some evidence China already is preparing for this eventuality by limiting the export of high-carbon products to consumer states with strong climate-protection laws. For example, the EU last year rolled out a Carbon Border Adjustment Mechanism (CBAM), which it describes as "a climate measure that should prevent the risk of carbon leakage and supports the EU's increased ambition on climate mitigation, while ensuring WTO compatibility."6 Investment Implications Governments are moving quickly to address shortcoming in existing CO2 and GHG reduction policies. Among other things, the EU and US are proposing mandatory reporting on these emissions covering Scope 1, 2 and 3 emissions. In addition, China is refining its five-year plan to limit high-carbon exports, so that it does not run afoul of the EU's CBAM. We expect more of such measures going forward, as CO2 and GHG emissions continue to accumulate in the atmosphere at a rate that cannot be offset by existing policy.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Footnotes 1     Scope 1 covers GHG emissions firms directly generate on their own; Scope 2 applies to emissions indirectly created a purchasing electricity and other forms of energy; and Scope 3 covers indirect emissions produced up and down the firms' supply chain.  These are deemed to be material risks that could impact firms' revenues and profitability, hence necessary information for investors and market participants generally.  Please see SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors, published by the SEC on March 21, 2022. 2     For more information on this, please see ScienceDirect’s page on the Environmental Kuznets Curve.  3    Please see Country-based rate of emissions reductions should increase by 80% beyond nationally determined contributions to meet the 2 degree Celsius target (Liu and Rafter, 2021), published in Nature. 4    Please see Surging Metals Prices And The Case For Carbon-Capture, which we published on May 13, 2021. It is available at ces.bcaresearch.com. 5    Please see Nordhaus, William (2015), "Climate Clubs: Overcoming Free-riding in International Climate Policy," American Economic Review 105:4, pp. 1339–1370. 6    Please see Carbon Border Adjustment Mechanism: Questions and Answers, published by the European Commission on July 14, 2021. See also China issues guidelines under 14th 5-year plan to limit high-carbon product exports, published by S&P Global Platts on April 7, 2022. Platts notes this likely will be China's first FYP to include limits on "high-carbon products from the (refining and petrochemical) industry amid China's carbon neutrality journey. This comes amid expectations that foreign countries may levy tariffs like the EU's Cross Border Adjustment Mechanism, or CBAM, on such products in the future." Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022   Image

Highlights All four of our US Equity indicators are currently pointing in a bearish direction. Our Monetary Indicator has fallen to a three decade low, our Technical Indicator has broken into negative territory, our Valuation Indicator still signals extreme equity pricing, and our Speculation Indicator does not yet support a contrarian buy signal. Still, we do not expect a US recession over the coming year, which implies that S&P 500 revenue growth will stay positive. Nonrecessionary earnings contractions are rare, and are almost always associated with a significant contraction in profit margins. Our new profit margin warning indicator currently suggests the odds of falling margins are low, although the risks may rise later this year. Stocks are extremely expensive, but rich valuations are being driven by extremely low real bond yields, rather than investor exuberance. Valuation is unlikely to impact US stock market performance significantly over the coming year unless long-maturity bond yields rise substantially further. Technical analysis of stock prices has a long and successful history at boosting investment performance, which ostensibly suggests that investors should be paying more attention to technical conditions in the current environment. However, technical trading rules have been less helpful in expansionary environments when inflation is above average and when stock prices and bond yields are less likely to be positively correlated (as is currently the case). As such, the recent technical breakdown of the US equity market may simply reflect a reduced signal-to-noise ratio associated with these economic and financial market regimes. For now, we see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio over the coming 6 to 12 months. Rising odds of a recession, declining profit margins, and a large increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market, the risks of which should be monitored closely by investors. Feature In Section 1 of our report, we reviewed why a recession in the US is unlikely over the coming 6 to 12 months. However, we also highlighted that the risks to the economic outlook are meaningful and that an aggressively overweight stance toward risky assets is currently unwarranted. During times of significant uncertainty, investors should pay relatively more attention to long-term economic and financial market indicators with a reliable track record. In this report we begin by briefly reviewing the message from our US Equity Indicators, and then turn to a deeper examination of the top-down outlook for earnings, the determinants of rich valuation in the US stock market, and whether investors should rely on technical indicators in the current environment. We conclude that, while an indicator-based approach is providing mixed signals about the US equity market, we generally see our indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. Aside from tracking the risk of a recession, investors should be closely attuned to signs of a contraction in profit margins or shifting neutral rate expectations as a basis to reduce equity exposure to below-benchmark levels. A Brief Review Of Our US Equity Indicators Chart II-1Our Equity Indicators Are Pointing In A Bearish Direction Our Equity Indicators Are Pointing In A Bearish Direction Our Equity Indicators Are Pointing In A Bearish Direction Chart II-1 presents our US Equity Indicators, which we update each month in Section 3 of our report. We highlight our observations below: Chart II-1 shows that our Monetary Indicator has fallen to its lowest level since 1995, when the Fed surprised investors and shifted rapidly in a hawkish direction. The indicator is most acutely impacted by the speed of the rise in 10-year Treasury yields and a massive surge in the BCA Short Rate Indicator to levels that have not prevailed since the late 1970s (Chart II-2). Our Technical Indicator has recently broken into negative territory, which we have traditionally interpreted as a sign to sell stocks. The indicator has been dragged lower by a deterioration in stock market breadth across several tracked measures and by weak sentiment (Chart II-3). The momentum component of the indicator is fractionally positive but is exhibiting clear weakness. Our Valuation Indicator continues to highlight that US equities are extremely overvalued relative to their history, despite the recent sell-off in stock prices. Our Speculation Indicator arguably provides the least negative signal of our four indicators, at least from a contrarian perspective. In Q1 2021, the indicator nearly reached the all-time high set in March 2000, but it has since retreated significantly and has exited extremely speculative territory. While this may eventually provide a positive signal for stocks, equity returns have historically been below average during months when the indicator declines. Thus, the downtrend in the Speculation Indicator still points to weakness in stock prices, at least over the nearer term. Chart II-2Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Our Monetary Indicator Is Falling In Part Because Of Surging Interest Rate Expectations Chart II-3All Three Components Of Our Technical Indicator Are Falling All Three Components Of Our Technical Indicator Are Falling All Three Components Of Our Technical Indicator Are Falling In summary, all four of our US Equity indicators are currently pointing in a bearish direction, which clearly argues against an aggressively overweight stance favoring equities within a multi-asset portfolio. At the same time, we reviewed the odds of a US recession over the coming year in Section 1 of our report and argued that a recession is not likely over the coming 12 months. Thus, one key question for investors is whether a nonrecessionary contraction in earnings is likely over the coming year. We address this question in the next section of our report, before turning to a deeper examination of the relative importance of equity valuation and technical indicators. Gauging The Risk Of A Nonrecessionary Earnings Contraction Chart II-4Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Nonrecessionary Earnings Declines Usually Occur Due To Falling Margins Based on S&P data, there have been five cases since 1960 when 12-month trailing earnings per share fell year-over-year, while the economy continued to expand (Chart II-4). Sales per share growth remained positive in four of these cases (panel 2), underscoring that falling profit margins have been mostly responsible for these nonrecessionary earnings declines. We have noted our concern about how elevated US profit margins have become and have argued that a significant further expansion is not likely to occur over the coming 12-24 months.1 To gauge the risk of a sizeable decline in margins over the coming year, we construct a new indicator based on the seven instances when S&P 500 margins fell outside the context of a recession. This includes two cases when margins fell but earnings did not (because of buoyant revenue growth). We based the indicator on these five factors: Changes in unit labor cost growth to measure the impact of wage costs on firm profitability; Lagging changes in commodity prices as a proxy for material costs; The level of real short-term interest rates as a proxy for borrowing costs; Changes in a sales growth proxy to measure the impact of operating leverage on margins; And changes in the ISM manufacturing index to capture any residual impact on margins from the business cycle. Chart II-5The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low The Odds Of A Nonrecessionary Profit Margin Contraction Are Currently Low Chart II-5 presents the indicator, which is shaded both for recessionary periods and the seven nonrecessionary margin contraction episodes we identified. While the indicator does not perfectly predict margin contractions outside of recessions, it did signal 50% or greater odds of a margin contraction in four of the seven episodes we examined, and signals high odds of a contraction in margins during recessions. Among the three cases in which the indicator failed to indicate falling margins during an expansion, two of those failures were episodes when earnings growth did not ultimately contract. The inability to explain the 1997-1998 margin contraction is the most relevant failure of the indicator, in addition to two false signals in 1963 and 1988. Still, the approach provides a useful framework to gauge the risk of falling profit margins, and the results provide an interesting and somewhat surprising message about the relative importance of the factors we included. We would have expected that accelerating wages would have been the most significant factor explaining nonrecessionary profit margin declines. Wages were highly significant, but they were the second most important factor behind our sales growth proxy. Lagged commodity prices were the third most significant factor, followed by real short-term interest rates. Changes in the ISM manufacturing index were least significant, underscoring that our sales growth proxy already captures most of the effect of the business cycle on profit margins. This suggests that operating leverage is an important determinant of margins during economic expansions, and that investors should be most concerned about declining profit margins when both revenue growth is slowing significantly and wage growth is accelerating. The indicator currently points to low odds of a nonrecessionary margin contraction, but this is likely to change over the coming year. We expect that all five of the factors will evolve in a fashion that is negative for margins over the coming twelve months: While the pace of its increase is slowing, median wage growth continues to accelerate, even when adjusting for the fact that 1st quartile wage growth is growing at an above-average rate (Chart II-6). Combining the latter with higher odds of at or below-trend growth this year implies that unit labor costs may rise further over the coming twelve months. Analysts expect S&P 500 revenue growth to slow nontrivially over the coming year (Chart II-7). Current expectations point to growth slowing to a level that would still be quite strong relative to what has prevailed over the past decade; however, accelerating wage costs in lockstep with decelerating revenue growth is exactly the type of combination that has historically been associated with falling margins during economic expansions. Chart II-6Wage Growth Is Accelerating... Wage Growth Is Accelerating... Wage Growth Is Accelerating... Chart II-7...And Revenue Growth Is Set To Slow ...And Revenue Growth Is Set To Slow ...And Revenue Growth Is Set To Slow ​​​​​​ Although these are less impactful factors, the lagged effect of the recent surge in commodity prices will also weigh on margins over the coming year, as will rising real interest rates and a likely slowdown in manufacturing activity in response to slower goods spending. In addition to our new indicator, we have two other tools at our disposal to track the odds of a decline in profit margins over the coming year. First, Chart II-8 illustrates that an industry operating margin diffusion index does a decent job at leading turning points in S&P 500 profit margins, despite its volatility. And second, Chart II-9 highlights that changes in the sales and profit margin diffusion indexes sourced from the Atlanta Fed’s Business Inflation Expectations Survey have predicted turning points in operating sales per share and margins over the past decade. Chart II-9 does suggest that profit margins may not rise further, but flat margins are not likely to be a threat to earnings growth over the coming year if a recession is avoided (as we expect). Chart II-8Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Sector Diffusion Indexes Are Not Signaling A Major Warning Sign For Margins... Chart II-9...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes ...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes ...Neither Are The Atlanta Fed Business Sales And Margin Diffusion Indexes     The conclusion for investors is that the odds of a decline in profit margins over the coming year are elevated and should be monitored, but are seemingly not yet imminent. In combination with expectations for slowing revenue growth, this implies, for now, that earnings growth over the coming year will be low but positive. Valuation, Interest Rates, And The Equity Risk Premium As noted above, our Valuation Indicator continues to highlight that US Equities are extremely overvalued relative to their history. Our Valuation Indicator is a composite of different valuation measures, and we sometimes receive questions from investors asking about the seemingly different messages provided by these different metrics. For example, Chart II-10 highlights that equity valuation has almost, but not fully, returned to late-1990 conditions based on the Price/Earnings (P/E) ratio, but is seemingly more expensive based on the Price/Book (P/B) and especially Price/Sales (P/S) ratios. In our view, this apparent discrepancy is easily resolved. Relative to the P/E ratio, both the P/B and especially P/S ratios are impacted by changes in aggregate profit margins, which have risen structurally over the past two decades because of the rising share of broadly-defined technology companies in the US equity index (Chart II-11). Barring a major shift in the profitability of US tech companies over the coming year, we do not see discrepancies between the P/E, P/B, or P/S ratios as being particularly informative for investors. As an additional point, we also do not see the Shiller P/E or other cyclically-adjusted P/E measures as providing any extra information about the richness or cheapness of US equities today, as these measures tend to move in line with the 12-month forward P/E ratio (Chart II-12). Chart II-10US Equities Are Extremely Overvalued, Based On Several Valuation Metrics US Equities Are Extremely Overvalued, Based On Several Valuation Metrics US Equities Are Extremely Overvalued, Based On Several Valuation Metrics Chart II-11Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis Tech Margins Have Caused Stocks To Look Especially Expensive On A Price/Sales Basis In our view, rather than focusing on different measures of valuation, it is important for investors to understand the root cause of extreme US equity prices, as well as what factors are likely to drive equity multiples over the coming year. As we have noted in previous reports, the reason that US stocks are extremely overvalued today is very different from the reason for similar overvaluation in the late 1990s. Charts II-13 and II-14 present two different versions of the equity risk premium (ERP), one based on trailing as reported earnings (dating back to 1872), and one based on twelve-month forward earnings (dating back to 1979). Chart II-12The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation The Shiller P/E Ratio Does Not Convey Any 'New' Information About Valuation Chart II-13The Equity Risk Premium Is In Line With Its Historical Average… The Equity Risk Premium Is In Line With Its Historical Average The Equity Risk Premium Is In Line With Its Historical Average The ERP accounts for the portion of equity market valuation that is unexplained by real interest rates, and the charts highlight that the US ERP is essentially in line with its historical average based on both measures, in sharp contrast to the stock market bubble of the late 1990s. This underscores that historically low interest rates well below the prevailing rate of economic growth are the root cause of extreme equity overvaluation in the US (Chart II-15), meaning that very rich pricing can be thought of as “rational exuberance.” Chart II-14…In Sharp Contrast To The Late 1990s ...In Sharp Contrast To The Late 1990s ...In Sharp Contrast To The Late 1990s Chart II-15US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low US Equities Are Extremely Expensive Because Bond Yields Are Extremely Low     Chart II-16The Equity Risk Premium Is Fairly Well Explained By The Misery Index The Equity Risk Premium Is Fairly Well Explained By The Misery Index The Equity Risk Premium Is Fairly Well Explained By The Misery Index Over the longer term, the risks to US equity valuation are clearly to the downside, as we detailed in our October 2021 report.2 But over the coming 6 to 12 months, US equity multiples are likely to be flat or modestly up in the US. As we noted in Section 1 of our report, a significant further rise in long-maturity bond yields will likely necessitate a major shift in neutral rate expectations on the part of investors and the Fed, which we think is more likely a story for next year than this year. And Chart II-16 highlights that the ERP has historically been well explained by the sum of unemployment and inflation (the Misery Index), which should come down over the coming several months as inflation moderates and the unemployment rate remains low. To conclude, it is absolutely the case that US equities are extremely expensive, but this fact is unlikely to impact US stock market performance significantly unless long-maturity bond yields rise substantially further. Technical Analysis Amid A Shifting Economic Regime Technical analysis of financial markets, and especially stocks, has a long history. It has also provided disciplined investors with significant excess returns over time. A simple stock / bond switching rule based on whether stock prices were above their nine-month moving average at the end of the previous month has significantly outperformed since the 1960s, earning an average excess annual return of 1.3% relative to a 60/40 stock/bond benchmark portfolio (Chart II-17). This outsized performance has come at the cost of only a minor increase in portfolio volatility. Ostensibly, then, investors should be paying more attention to equity technical conditions in the current environment, which we noted above are not positive. Our Technical Indicator has recently broken into negative territory, and the S&P 500 has clearly fallen back below its 200-day moving average. However, Chart II-17 presented generalized results over long periods of time. Over the past two decades, investors have been able to rely on a durably negative correlation between stock prices and bond yields to help boost portfolio returns from technically-driven switching rule strategies. Chart II-18 highlights that this correlation has been much lower over the past two years than has been the case since the early 2000s, raising the question of whether similar switching strategies are viable today. In addition, there is the added question of whether technical analysis is helpful to investors during certain types of economic and financial market regimes, such as high inflation environments. Chart II-17Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Technically-Driven Trading Rules Have Historically Provided Investors With A Lot Of Alpha Chart II-18Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated Switching-Rule Strategies May Not Work As Well When Stock Prices And Bond Yields Are Not Positively Correlated To test whether the message from technical indicators may be relied upon today, we examine the historical returns from a technically-driven portfolio switching strategy during nonrecessionary months under four conditions that reflect the economic and political realities currently facing investors: months when both stock and bond returns are negative; months of above-average inflation; months of above-average geopolitical risk; and the 1970s, when the Misery Index was very elevated. In all the cases we consider, the switching rule is simple: whether the S&P 500 index was above its nine-month moving average at the end of the previous month. If so, the rule overweights equities for the subsequent months; if not, the rule overweights a comparatively risk-free asset. We consider portfolios with either 10-year Treasurys or 3-month Treasury bills as the risk-free asset, as well as a counterfactual scenario in which cash always earns a 1% annual rate of return (to mimic the cash returns currently available to investors). Table II-1 presents the success and whipsaw rate of the trading rule. Table II-2 presents the annualized cumulative returns from the strategy. The tables provide three key observations: As reflected in Chart II-17, both Tables II-1 and II-2 highlight that simple technical trading rules have historically performed well, and that outperformance has occurred in both recessionary and nonrecessionary periods. Relative to nonrecessionary periods overall, technical trading rules have underperformed during the particular nonrecessionary regimes that we examined. It is the case not only that these strategies have performed in inferior ways during these regimes, but also that they were less consistent signals in that they generated significantly more “whipsaws” for investors. Among the four nonrecessionary regimes that we tested, technical indicators underperformed the least during periods of above-average geopolitical risk, and performed abysmally during nonrecessionary (but generally stagflationary) months in the 1970s. Table II-1During Expansions, Technically-Driven Switching Rules Underperform… May 2022 May 2022 Table II-2…When Inflation Is High And When Stocks And Bonds Lose Money May 2022 May 2022 The key takeaway for investors is that technical analysis is likely to be helpful for investors to improve portfolio performance as we approach a recession but may be less helpful in an expansionary environment in which inflation is above average and when stock prices and bond yields are less likely to be positively correlated. Investment Conclusions Echoing the murky economic outlook that we detailed in Section 1 of our report, our analysis highlights that an indicator-based approach is providing mixed signals about the US equity market. On the one hand, all four of our main equity indicators are currently providing a bearish signal, and the risk of a nonrecessionary contraction in S&P 500 profit margins over the coming year is elevated – albeit seemingly not imminent. On the other hand, our expectation that the US will not slip into recession over the coming year implies that revenue growth will stay positive, which has historically been associated with expanding earnings. In addition, US equity multiples are likely to be flat or modestly up, and the recent technical breakdown in the S&P 500 may simply reflect a reduced signal-to-noise ratio that appears to exist in expansionary environments in which inflation is high and the stock price / bond yield correlation is near-zero or negative. Netting these signals out, we see our equity indicators as supportive of a cautious, minimally-overweight stance toward stocks within a multi-asset portfolio. The emergence of a recession, declining profit margins, and a significant increase in investor or Fed expectations for the neutral rate of interest are the most significant threats to the equity market. We will continue to monitor these risks and adjust our investment recommendations as needed over the coming several months. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1     Please see The Bank Credit Analyst “OUTLOOK 2022: Peak Inflation – Or Just Getting Started?” dated December 1, 2021, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst “The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms,” dated September 30, 2021, available at bca.bcaresearch.com