Economy

Dear client,  In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio.  Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy.  More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF).  Market/Sector Recommendations Cyclical Investment Stance

Special Report

Highlights Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory. Investors in Chinese TMT/new economy stocks are facing uncertainty on multiple fronts which warrants lower valuation multiples. These companies will experience weaker profit growth and lower profitability relative to the past due to disruptions to their business models. Elsewhere, widening credit spreads among Chinese property developers reflects the property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. This poses a material risk to raw material prices and, consequently, EM in general. Feature Chart 1Chinese Growth/TMT Share Prices And P/E Ratio The Chinese MSCI Investable Growth stock index is down by 35% from its February peak (Chart 1, top panel). Such a drawdown in the previous market leaders has produced a temptation to buy. The enticement is especially strong given that US FAANGM stocks are hitting new all-time highs. Is the latest crash in Chinese new economy/growth/TMT stocks a bad dream that will soon end, or does it mark a new reality for these companies? In our opinion, Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory but is a part of China’s ongoing transformation. In brief, these companies are facing a new reality. What’s more, their outlook is very uncertain and equity valuations are not low enough to offset potential risks related to owning these stocks. Overall, investors should not start bottom fishing in Chinese stocks in general and Chinese TMT stocks in particular. Uncertainty = Lower Equity Multiples Immense uncertainty surrounds the outlook for Chinese TMT share prices. Even though China’s growth stocks have been de-rated, their trailing P/E ratio remains at 36.5 (Chart 1, bottom panel). Table 1A Snapshot Of Drawdown And Valuations Table 1 shows the drawdowns and trailing P/E ratios for TMT/new economy/growth indexes as well as their largest constituencies: Alibaba, Tencent and Meituan. These equity multiples are still high given the uncertainty these companies are facing. By extension, investors in Chinese TMT/new economy stocks are also facing uncertainty on multiple fronts: Regulatory crackdowns mean that the business models of many of these companies will have to undergo substantial changes. Corporations may need to overhaul their product lines or abandon existing products/markets and find new niches and introduce new offerings. It is impossible to know what the long-term revenue and profit growth rates of these companies will be so that they can be properly valued. Such heightened uncertainty about the long-term outlook warrants a higher equity risk premium and, hence, lower equity multiples. President Xi Jinping’s long-term objective is to reduce income equality and achieve more equal wealth distribution. There will therefore be little tolerance for excessive profitability of individual companies. Chart 2 illustrates the large income gap between the top 10% and bottom 50% of the population. In turn, the mean-to-median wealth ratio points to a large and rising wealth gap – a higher ratio reflects greater wealth concentration among rich households (Chart 3). Chart 2China: Income Disparity Has Not Been Narrowing Chart 3Wealth Concentration Remains High In China   President Xi’s goal is to appease the broader population, not shareholders or businesses. Top authorities have been using phrases such as “disorderly expansion of capital” since last fall. This language marked a major shift in government policies regarding market power and dominance of private companies. Investors should take note that they are now dealing with a new investment regime in China. For some time, we have argued that China’s regulatory tightening on private platform companies would aim to limit their monopolistic or oligopolistic power and ration their profitability. As a result, we alleged that these new economy companies would end up being regulated like utilities or become quasi-government entities. Consequently, their profitability would decline to close to that of utilities or SOEs. Yet, utility stocks or SOEs in China command much lower equity multiples than those at which platform companies’ stocks have been trading. Even as of today, the trailing P/E ratio on the China MSCI Growth Investable index is 36.5. Meanwhile, global utility stocks command a trailing P/E ratio of 19. It is hard to know where the P/E ratios of these Chinese TMT stocks will settle, but our hunch is that their multiple compression is not over yet. Regulatory clampdowns will not only curtail their revenues and pricing power but also increase their costs. These companies will need to spend money to comply with the new regulatory regime. They will, for instance, be expected to take on more in the way of social responsibilities, as SOEs in China have been doing. This and other measures will eat into their profit margins and will lower the return on capital. Finally, many Chinese TMT companies that have their ADRs listed in the US have been caught in the crossfire of the “big data war” between the US and China. On the one hand, US authorities want to oblige these Chinese issuers to comply with US regulations in terms of information and risks disclosure. On the other hand, Chinese authorities are reluctant to allow more data/information disclosure by their dominant platform companies to foreign investors. Given that the US-China confrontation is likely to escalate on many fronts going forward, odds are low that there will be a lasting solution to this conflict around US-traded Chinese equities. Authorities in the Middle Kingdom are not very sensitive to the fact that foreign shareholders are losing money in Chinese offshore trading stocks. Unless the crash in offshore stocks spills into the domestic financial markets and the economy, their willingness to compromise will be limited. In turn, the US will not “encourage” American investors to invest more in Chinese stocks where its regulatory authority and influence is weak. Overall, such high uncertainty regarding offshore Chinese stocks in general and the ones trading in the US in particular warrants a higher equity risk premium and lower equity multiples. Despite these negatives, there is a silver lining: China’s new economy segments have been and will continue expanding at a rapid pace. Chinese authorities are genuinely interested in supporting new economy sectors which could help boost productivity and be growth engines as the growth contribution from construction/infrastructure/manufacturing diminishes. The challenge for investors is to find companies that benefit from the continued expansion of new economy sectors, and acquire their stocks at reasonable multiples to secure limited drawdowns during market selloffs. Bottom Line: Chinese growth stocks/TMT share prices – on the index level – remain at risk of further de-rating/multiple compression. These companies also face potentially weaker profit growth and lower profitability compared to the past due to disruptions to their business models and/or higher costs of doing business. A Breakdown In Chinese Property Stocks And Bonds Is Flying Under The Radar Chart 4Property Stocks And Bond Prices Have Crashed While Chinese TMT stocks are at the center of the global investment community’s interest, there has been a breakdown in mainland real estate share prices and a spike in property companies’ offshore credit spreads (Chart 4). The rising cost of capital imply that real estate developers will curtail their new property launches and construction. In addition, authorities will not ease regulatory tightening in the property market in general and property companies in particular. The objective is to halt the rise in property prices so that the continuous increase in personal income brings down the household income-to-property price ratio. The latter is extremely high in China making housing unaffordable for average Chinese. Authorities are very sensitive to the issue of housing unaffordability. Not only are property developers under pressure from tightening but also authorities are curbing demand for housing. In particular, two weeks ago the PBoC ordered banks in Shanghai to raise the rate of mortgage loans for first-time homebuyers to 5% from 4.65% and for people who are buying second homes to 5.7% from 5.25%. This measure might be extended to other tier-1 cities if house prices do not stop rising. As a result of the clampdown on property developers and move to restrain investment/speculative demand for housing, construction activity will shrink. The top panel of Chart 5 illustrates that the level of aggregate building construction starts has turned down. Residential property sales are decelerating and starts are contracting (Chart 5, bottom panel). Bottom Line: Property construction in China will start shrinking in the coming months. This will spill into other industrial/manufacturing sectors that supply construction and produce durable consumer goods. Chinese industrial output is set to decelerate materially as is predicted by a relapse in the nation’s manufacturing PMI’s new and backlog orders (Chart 6). This poses a material risk to raw material prices and, consequently, to EM in general. Chart 5Chinese Property Construction Is Set To Contract Chart 6China's Manufacturing To Decelerate   Investment Conclusions From a short-term perspective, Chinese growth stocks are oversold, however this is not true from a long-term perspective. As shown in the top panel of Chart 1 above, the Chinese MSCI Investable Growth Stock Index is only back to its June 2020 levels. In fact, the parabolic rise in Chinese TMT stocks in late 2020 and early 2021 reflected investor euphoria that typically occurs at the end of a major bull market. Hence, the February peak in these equities could mark a major top. If so, these stocks are unlikely to embark on a sustainable bull market any time soon. For now, investors should fade rebounds in Chinese TMT stocks. We have been overweight Chinese stocks within an EM equity portfolio but this has been a bad call. However, among Chinese stocks we have recommended the following strategy since March 4th of this year: long A shares/short Investable stocks. The basis has been that we foresaw more downside risks in TMT stocks than onshore equities indexes (Chart 7). This recommendation is up by 15.5% since then and investors should maintain this strategy. Chart 7Stay Long Chinese A-Shares / Short Offshore Trading Stocks Chinese equities are oversold relative to the EM index, and we are reluctant to downgrade them now. We are also waiting for our view of the continued US dollar rebound and lower commodities prices to play out before we downgrade Chinese equities. Other EM bourses typically underperform when the US dollar rallies and commodities sell off markedly. As we argued in last week’s report, the weakness in EM equities has not been limited to Chinese TMT stocks. EM ex-TMT share prices have also rolled over, which is consistent with rising EM corporate bond yields (Chart 8). Chart 8Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Although most of the rise in EM corporate bond yields/spreads can be attributed to Chinese property companies, their widening credit spreads reflect the mainland property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. Notably, Chart 9 reveals that there has been a widening gap between a declining Chinese manufacturing PMI and resilient industrial metals prices. Odds are that commodity prices will recouple with China’s manufacturing PMI to the downside. Chart 9An Unsustainable Divergence: Beware Of Risks To Commodity Prices We continue to recommend underweighting EM versus DM for global equity and credit portfolios, a strategy we initiated on March 25, 2021. We also recommend shorting a basket of EM currencies versus the US dollar and maintaining a cautious stance on commodity prices. The full list of our country recommendations for equity, fixed-income and currency investors is available at the end of this report. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  

Highlights US Treasuries: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. The spread of the Delta variant in the US represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe is a positive sign that the US can see a similar result and avoid a major economic hit. Stay below-benchmark on US duration exposure. UK: The Bank of England is starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge is losing momentum. UK Gilt yields are vulnerable to a hawkish repricing with only 48bps of rate hikes discounted by the end of 2024. Stay below-benchmark on UK duration exposure, and downgrade Gilts to underweight in global bond portfolios. A New Turning Point For Global Bond Yields? After seeing steady declines since the peak in late March that took the yield down to an intraday 2021 low of 1.13% last week, the 10-year US Treasury experienced a rebound back to 1.30% in a span of just three days. Yields in typically “high-beta” countries like Canada and Australia also saw significant increases. There were two main triggers for the pickup in US yields. Firstly, a speech from Fed Vice-Chair Richard Clarida was interpreted hawkishly, as he stated that he expects the conditions necessary for the Fed to begin lifting rates would be met by the end of 2022. Secondly, a better-than-expected July employment report confirmed the strength of the US labor market already evident in booming demand indicators like job openings. A third potential cause of the trough in yields can be found outside the US in the increasingly positive news on the spread of the Delta variant coming out of the UK. We would argue that the more relevant turning point for global bond yields in 2021 was not the late March peak in the US, but the mid-May peak in non-US developed market yields. The 10-year UK Gilt yield reached its 2021 apex on May 13, just as the spread of the Delta variant was starting to push UK COVID-19 case numbers sharply higher – despite the high vaccination rate in that country (Chart of the Week). This raised the fears that the “reopening boom” could stall, not only in the UK but other major economies, at a time when global growth momentum was already starting to cool off from the overheated pace in the first half of the year. Chart of the WeekThe "Delta Rally" In Bond Markets Is Fading The Delta variant wave continues to wash over the US, although primarily in regions with lower vaccination rates. There was little sign of any impact from the variant in the July US jobs data with just over one million new jobs added (including revisions to prior months) and the unemployment rate falling one-half of a percentage point to 5.4%, the lowest level since March 2020 (Chart 2). However, we will need to see more economic data from July and August to confirm that this latest wave is not having a material impact on the broad US economy beyond the regions with lower vaccination rates. New COVID-19 cases in the UK peaked in mid-July, and are rolling over in continental Europe, with relatively low hospitalization rates – a hopeful sign that the US Delta spread could also soon begin to lose momentum. We continue to believe that steady improvements in the US labor market will be the driver of higher US bond yields over at least the next 6-12 months, as falling unemployment will embolden the Fed to begin tapering asset purchases and, eventually, begin rate hikes towards the end of 2022. The technical backdrop for Treasuries has become less of a headwind to higher yields, with the 10-year yield falling back to its 200-day moving average and speculators closing a lot of short positioning in Treasury futures (Chart 3). If the US can follow the more positive news from across the Atlantic with regards to the spread of the Delta variant, this would remove another impediment to higher US bond yields. Chart 2Steady Progress Towards The Fed's Employment Goals Bottom Line: US Treasury yields are rising once again, in response to typical drivers – less dovish Fed commentary and upside growth surprises. Chart 3Technical Backdrop Less Of A Headwind To Higher US Yields The surge in Delta variant cases represents a potential near-term roadblock to additional yield increases, but the recent slowing of new cases in the UK and Europe may be a positive sign that the US will avoid a major economic hit. Stay below-benchmark on US duration exposure. A Gilt-Bearish Shift In Tone From The Bank Of England Chart 4Pressures Building On The BoE To Dial Back Stimulus BCA Research’s Global Fixed Income Strategy has had the UK on “downgrade watch” over the past few months. Improving growth momentum and recovering inflation have raised the risks of a more hawkish turn by the Bank of England (BoE), as evidenced by the elevated reading from our UK Central Bank Monitor (Chart 4). At the same time, the spread of the Delta variant injected a note of caution into an otherwise positive UK economic story. We now think it is time to move from “downgrade watch” to a full downgrade of our current neutral stance on UK Gilts. The BoE left its policy settings unchanged at last week’s policy meeting, but did provide strong indications that some removal of monetary accommodation would soon be necessary. The central bank noted that the UK economy was recovering from the pandemic shock at a faster-than-expected pace. In the August Monetary Policy Report (MPR) also released last week, the BoE maintained its 2021 real GDP growth forecast at 7.25% while slightly raising its 2022 growth estimate to 6%. UK GDP is now projected to fully recover to the pre-COVID level by the end of 2021. More importantly, the projections for the unemployment rate were lowered substantially. The central bank no longer expects much of an impact on unemployment when the UK government’s job-protecting furlough scheme expires in September. The BoE now expects unemployment to peak at 5.1% in Q3/2021 (Chart 5), a big change from the 6% projection in the May MPR, with the central bank noting that job vacancies are already back to pre-pandemic levels. The unemployment rate is projected to reach 4.25% in both 2022 and 2023. Chart 5Major Changes To The BoE's Forecasts The BoE baseline forecast now calls for UK headline CPI inflation to see a temporary surge to 4% in Q4/2021 – a significant change from the 2.5% peak in inflation projected in the May MPR - before returning back to close to 2% over the next two years. Yet the minutes of last week’s policy meeting noted that the medium-term risks surrounding inflation were “two-way”, a message that sounds a bit more concerning compared to the benign 2022/23 inflation projections. The BoE is now running the risk of underestimating how long the UK inflation uptrend can persist and force increases in interest rates – perhaps beginning as soon as mid-2022 – given the multiple factors that are pushing up inflation. A modest growth hit from the Delta variant The daily number of new cases has fallen by nearly one-half since the peak on July 20th, according to the Oxford University data (Chart 6). Hospitalizations are also rolling over at a peak that would be one-quarter the size of the January peak. If these trends continue, this latest wave of COVID will not have a lasting negative impact on the economy that would dampen inflation pressures. The modest dip in the UK manufacturing and services PMIs in June and July, when cases were rising, supports this conclusion. Accelerating wage growth UK job vacancies are now higher than the pre-pandemic peak, while the BoE’s Agents’ Survey of companies reports an increasing number of firms reporting recruitment difficulties across a broader range of industries (Chart 7). The job market frictions are similar to the dynamics currently at play in the US, where labor demand is booming but firms have struggled to fill openings because government pandemic support programs have dampened labor market participation. Chart 6The Biggest Threat To The Dovish BoE Stance Chart 7Good Help Is Hard To Find In The UK The BoE noted in the August MPR that its forecasts include the impact of labor market frictions that have temporarily raised the medium-term equilibrium rate of unemployment during the pandemic, resulting in a surge in wage growth. However, this effect is expected to fade as the economy normalizes and government support programs expire. For example, the BoE estimates that the UK government’s job retention “furlough” scheme, which pays a reduced wage to workers who cannot work because of COVID economic restrictions and which expires in September, has acted to dampen measured wage growth over the past year. At the same time, compositional effects, with pandemic job losses being skewed towards lower-paying roles, have had a far greater impact in lifting wage growth. The BoE estimates that the “underlying” pace of wage growth, excluding pandemic effects, is only 3.3% compared to the reported 7.2%, but is expected to rise towards 4.5% in Q3 as the labor market recovers. Yet if the employment frictions do not fade as rapidly as the BoE expects, perhaps due to persistent skills mismatches for existing job openings, then the inflationary pressures emanating from the UK jobs market may cause UK inflation to stay elevated for longer than the BoE is projecting. Continued recovery from the initial COVID shock Chart 8Recovering From The COVID Recession The BoE now expects UK real GDP to return to its pre-pandemic level in Q4 of this year (Chart 8). Much of the recovery in activity seen so far has been in services as pandemic restrictions have been lifted. Looking forward, consumer spending will be boosted by improving growth momentum in employment and incomes, further underpinned by a high levels of household savings accumulated during the pandemic. Business investment is also expected recover, given the robust reading from the BoE Agents’ Survey of investment intentions (bottom panel). The twin engines of consumption and investment will be enough to keep the UK economy growing at an above-trend pace in 2022, even with a modest expected drag from fiscal policy, which should help maintain some of the current cyclical inflationary pressures. Rising house prices UK house prices are experiencing another sharp uptick, with the Nationwide index up 10.3% year-over-year in Q2 (Chart 9). Demand for homes has been boosted by the UK government’s holiday on stamp duty, or housing transaction taxes, which began last year as a form of pandemic economic support. Housing transactions spiked in June as demand surged ahead of the expiry of the stamp duty holiday last month, and some payback is likely in the near-term. Yet UK housing demand has also been supported by the same factors boosting house prices in most developed economies - low interest rates, high household savings available for down payments and the increased need for space for those choosing to work from home. UK house price inflation thus could remain higher for longer than the BoE expects. Chart 9Is This House Price Surge 'Transitory' Or Policy Driven? Supply Chain Bottlenecks The BoE noted in the August MPR that overall UK import prices have risen faster than expected, especially with the British pound higher on a year-over-year basis. UK firms have faced rising input costs because of disruption to global supply chains from the pandemic. For example, the annual growth rate of import prices for manufactured components rose by 12.1% in May, a sharp contrast to the -5.4% deflation of consumer goods prices (Chart 10). The BoE projects UK overall import price inflation to turn negative in 2022 and 2023, a big part of its slowing inflation forecast. Some decrease is inevitable as price momentum in oil and other commodities cools from overheated levels seen in 2021. However, supply chain disruptions are a global phenomenon already persisting for longer than expected in other countries and could linger into 2022 if global growth stays above trend - potentially causing UK import price inflation to once again exceed the BoE’s expectations. Summing it all up, the pressure is clearly building on the BoE to dial back the massive monetary easing put in place last year in response to the pandemic. Not only is the economy now recovering far more rapidly than the BoE had been projecting, with inflation set to peak at a higher level, but there are other indications that monetary conditions may now be too loose like accelerating house prices. There are numerous upside risks to the BoE’s benign post-2021 inflation forecasts, especially with the central bank also projecting the UK to have a positive output gap in 2022 and 2023 (Chart 11). Chart 10BoE Betting On Waning Global Supply Bottlenecks Markets are not expecting much from the BoE in terms of interest rate increases. While the UK overnight index swap (OIS) curve is now discounting an initial 25bp rate hike in August 2022, only one other 25bp increase is expected by the end of 2024 (Table 1). Chart 11Domestic Price Pressures On The Rise The BoE has not been a very active central bank since the 2008 financial crisis, never raising the Bank Rate above 0.75% over that time, thus the markets now seem conditioned to think that the BoE will continue to do very little in the future. Table 1Markets Expect The BoE To Hike Before The Fed Chart 12Markets Expect Persistent Negative UK Real Rates That is evident when you look at longer-dated OIS rates compared to forward inflation rates from the UK CPI swap curve. The combined message from those markets is that the BoE is expected to maintain deeply negative real interest rates for at least the next decade, a major reason why the UK has persistently negative real bond yields (Chart 12). A lower equilibrium real interest rate (i.e. “r-star”) is consistent with the declining trend in the OECD’s estimate of UK potential real GDP growth over the past 20 years (Chart 13). Yet it is a stretch to think that the neutral UK real interest rate is now negative, especially given how rapidly UK growth and inflation have snapped back from the 2020 COVID recession. UK interest rate markets are highly vulnerable to any hawkish shift by the BoE – and outcome that the current growth and inflation dynamics suggest is increasingly likely over the next 6-12 months. The BoE has already started to process of dialing back monetary accommodation by slowing the pace of asset purchases in its quantitative easing (QE) program (Chart 14). While no decision on additional tapering was made last week, the BoE did dedicate three pages of the August MPR to a detailed discussion on how the future size of the BoE’s balance sheet would likely be reduced if the BoE were to begin raising interest rates. There has also been some political pressure on the UK to dial back QE, with the Chair of the Economic Affairs Committee in the UK House of Lords saying that the BoE was “addicted” to QE last month. BoE Governor Andrew Bailey has previously stated that he viewed QE as a regular part of a central banker’s toolkit, to be used opportunistically during periods of deep economic or financial market stress. That made sense in 2020 during the height of the pandemic, but is no longer the case now. Chart 13UK R-Star Is Still Positive We anticipate that the BoE will end the current QE program sometime in the next six months, with an initial 25bp rate hike occurring sometime in mid-2022. Chart 14UK QE: Expect More Tapering This would be a faster pace of tapering, with a quicker liftoff, than the Fed, although we expect the Fed to eventually raise rates by more than the BoE in the next interest rate cycle. Investment Conclusions Given our expectation that the BoE is starting to prepare the markets for an unwind of its pandemic policy settings, we come to the following fixed income and currency investment conclusions (Chart 15): Chart 15Summarizing Our UK Fixed Income Recommendations Chart 16A More Hawkish BoE Would Benefit The Pound Duration: Maintain a below-benchmark duration stance within dedicated UK bond portfolios, with too few rate hikes discounted Country Allocation: Downgrade UK Gilts to underweight in global bond portfolios Yield Curve: On a tactical (0-6 months) basis, the UK Gilt curve may re-steepen as UK and global growth stays resilient, but a more hawkish BoE will eventually result in a flatter Gilt curve Inflation-Linked: Inflation breakevens on UK index-linked Gilts are already quite elevated and are overvalued on our fair value models, while real yields are at deeply negative levels that are conditioned on a continually dovish BoE – a combination that suggests an underweight stance on UK linkers is appropriate. Corporate Credit: Stay neutral on a tactical basis, as solid UK growth will offset the impact of a shift to a less dovish BoE. Currency: Our currency strategists are positive on the British pound - which is undervalued on their models (Chart 16) - over the medium-term, with the BoE seemingly on a path to begin tightening monetary policy sooner than the ECB and perhaps even the Fed.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Chart 2BDefining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Table 1BSurvey Of Primary Dealers Expected Fed Timeline Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields Chart 6Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns