Corporate Bonds

Highlights Chart 1Inflation Pressures Building Inflation Pressures Building Inflation Pressures Building As expected, base effects kicked in and pushed 12-month core PCE inflation from 1.37% to 1.83% in March. But a favorable comparison to last year’s depressed price level only explains part of inflation’s jump. Core PCE also rose at an annualized monthly rate of 4.4% in March, one of the highest readings seen during the past few years (Chart 1). Jerome Powell spoke about the Fed’s view of inflation at last week’s FOMC press conference and he reiterated that the Fed views current upward price pressures as transitory, the result of both base effects and temporary bottlenecks resulting from an economic re-opening where demand recovers more quickly than supply. Powell’s message is that the Fed won’t lift rates until the labor market returns to “maximum employment” and it won’t start tapering asset purchases until it sees “substantial further progress” toward that goal. Our view remains that the Fed will see enough improvement in the labor market to start tapering asset purchases in late-2021 or early-2022. It will also begin lifting rates before the end of 2022. As a result, we continue to recommend below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Table 2Fixed Income Sector Performance Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to +111 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. At 149 bps, the 2/10 Treasury slope is very steep and the 5-year/5-year forward TIPS breakeven inflation rate sits at 2.26% – almost, but not quite, equal to the lower-end of the 2.3% - 2.5% range that the Fed considers “well anchored”. The message from these two indicators is that the Fed is not yet ready to turn monetary policy more restrictive. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 1st percentile (Chart 2). This means that the breakeven spread has only been tighter 1% of the time since 1995. The same measure shows that Baa-rated bonds have only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better opportunities outside of the investment grade corporate space. Specifically, we advise investors to favor both tax-exempt and taxable municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Table 3BCorporate Sector Risk Vs. Reward* Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 70 basis points in April, bringing year-to-date excess returns up to +335 bps. In a recent report, we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.1 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4%, very close to what is priced into junk spreads. Given that the large amount of fiscal stimulus coming down the pike makes the Fed’s 6.5% real GDP growth forecast look conservative, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +26 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 5 bps in April. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) currently sits at 11 bps. This is considerably below the 51 bps offered by Aa-rated corporate bonds, the 33 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. In a recent report, we looked at recent MBS performance and valuation across the coupon stack.2 We noted that high coupon MBS have delivered strong excess returns versus Treasuries since bond yields troughed last August, while low coupon MBS have lagged (panel 4). This divergence occurred because the higher coupon securities are less negatively convex and thus their durations didn’t extend as much during the back-up in yields. Looking ahead, we recommend favoring 4% and 4.5% coupons and avoiding 2%, 2.5% and 3% coupons. The higher OAS and less negative convexity of those higher coupon securities will cause them to outperform in an environment of flat or rising bond yields. Lower coupon MBS only look poised to outperform in an environment of falling bond yields, which is not our base case. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Government-Related: Neutral The Government-Related index outperformed the duration-equivalent Treasury index by 6 basis points in April, bringing year-to-date excess returns up to +72 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 19 bps in April, dragging year-to-date excess returns down to +21 bps. Foreign Agencies outperformed the Treasury benchmark by 2 bps on the month, bringing year-to-date excess returns up to +34 bps. Local Authority bonds outperformed by 41 bps in April, bringing year-to-date excess returns up to +329 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +19 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +16 bps. We recently took a detailed look at USD-denominated Emerging Market (EM) Sovereign valuation.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Mexico, Russia, Indonesia, Colombia, Saudi Arabia, Qatar and UAE. We prefer US corporates over EM Sovereigns in the high-yield space where there is still some value left in US corporate spreads and where the EM space is dominated by distressed credits like Turkey and Argentina. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 17 basis points in April, bringing year-to-date excess returns up to +308 bps (before adjusting for the tax advantage). We took a detailed look at recent municipal bond performance and valuation in last week’s report and came to the following conclusions.4 First, the economic and policy back-drop is favorable for municipal bond performance. The recently passed American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that comes after state & local government revenues already exceeded expenditures in 2020 (Chart 6). President Biden has also proposed increasing income tax rates. Though these increases may not pass before the 2022 midterm, the threat of higher tax rates could increase interest in municipal bonds. Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down the quality spectrum to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates, while GO munis offer a breakeven tax rate of just 7% (panel 2). Fourth, taxable munis offer a yield advantage versus investment grade corporates (panel 3), one that investors should take advantage of. Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering investors a breakeven tax rate of 19% (panel 4). Despite the attractive spread, we only recommend a neutral allocation to high-yield munis versus high-yield corporates since high-yield munis’ deep negative convexity makes the sector prone to extension risk if bond yields should rise. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in April, even as the economic data continued to surprise on the upside. The 2/10 Treasury slope flattened 9 bps to end the month at 149 bps. The 5/30 slope flattened 5 bps to end the month at 144 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.5 Beyond 10 years, the curve has transitioned into a bear-flattening/bull-steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position in a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview ​​​​​​ TIPS outperformed the duration-equivalent nominal Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +394 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 4 bps and 5 bps on the month, respectively. At 2.43%, the 10-year TIPS breakeven inflation rate is near the top-end of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below the target band (panel 3). This week, we are downgrading our TIPS allocation from overweight to neutral for two reasons. First, as noted above, long-maturity breakevens are consistent with the Fed’s target. The Fed has so far welcomed rising TIPS breakeven inflation rates, but it will have an increasing incentive to lean against them if they continue to move up. Second, TIPS breakevens and CPI swap rates are even higher at the front-end of the curve – the 1-year CPI swap rate is currently 2.93% – and there is a good chance that those lofty expectations will not be confirmed by the realized inflation data. In addition to shifting from overweight to neutral on TIPS versus nominal Treasuries, we also book profits on our inflation curve flattener trade (panel 4) and on our real yield curve steepener (bottom panel). The inflation curve will likely stay inverted, but it will have difficulty flattening further unless short-maturity inflation expectations move even higher. The real yield curve may continue to steepen as bond yields rise, but without additional inflation curve flattening it is better to position for that outcome along the nominal Treasury curve. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to +19 bps. Aaa-rated ABS outperformed by 4 bps on the month, bringing year-to-date excess returns up to +13 bps. Non-Aaa ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +58 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and already the most recent round of stimulus is pushing the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfalls to pay down debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to +121 bps. Aaa Non-Agency CMBS outperformed Treasuries by 36 bps in April, bringing year-to-date excess returns up to +50 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 70 bps, bringing year-to-date excess returns up to +365 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to weaken and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in April, bringing year-to-date excess returns up to +87 bps. The average index option-adjusted spread tightened 4 bps on the month and it currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have completely recovered to their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 30TH, 2021) Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 30TH, 2021) Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 47 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 47 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of April 30TH, 2021) Fed Won’t Catch Inflation Fever Fed Won’t Catch Inflation Fever   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 2 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021. 4 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 5 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021.

Highlights On March 25, 2021, we downgraded EM sovereign and corporate credit to underweight relative to US corporate credit. This is a tactical downgrade for the next six months or so. China’s business cycle will be slowing, and the rest of EM will continue experiencing sluggish growth despite a US economic boom. Underwhelming revenue growth among EM borrowers will weigh on EM credit market performance. An impending slowdown in China and the ongoing US economic boom will likely benefit the US dollar and lead to lower commodity prices. This outlook warrants wider EM sovereign and corporate credit spreads. The risk to this view is that US bond/TIPS yields do not rise despite the very robust US economy. In such a case, the US dollar will fail to rally, and EM credit spreads are unlikely to widen. Nevertheless, EM credit markets will still underperform US corporate credit. Feature EM sovereign and corporate US dollar bonds and EM local currency government bonds are two distinct asset classes. They should not be compared. In a past report, we proposed that global asset allocators should consider EM sovereign and corporate USD bonds as part of a global credit portfolio that includes US corporate bonds. EM local currency government bonds are a unique asset class with idiosyncratic features and very low correlation with other assets. They should have their own place in a global diversified portfolio. This report delves into the drivers of EM USD bonds (EM credit markets) and another will focus on EM local currency bonds. What Drives EM USD Bonds? The total return on EM sovereign and corporate USD bonds can be decomposed into two components: (1) return on US Treasurys and (2) excess return from taking credit risk on EM governments and companies. Investors can get exposure to the first component by purchasing US government bonds. Hence, the only reason to invest in EM sovereign and corporate US dollar bonds versus US Treasurys is to earn excess returns by taking on EM credit risk. EM sovereign and corporate credit spreads are driven by borrowers’ ability and willingness to service debt. Doubts about willingness to service debt are rare and standard analysis often focuses on debtors’ ability to pay interest and principal on their debt. Foreign currency debt servicing ability is contingent on: (1) the borrower’s debt burden (i.e. the debt-to-revenue ratio), (2) the borrower’s revenue dynamics, (3) exchange rate fluctuations and (4) interest rates. For foreign currency debt, the exchange rate plays a critical role in determining both the debt burden and the cost of debt servicing. Currency depreciation increases the foreign currency debt burden and debt servicing costs, while currency appreciation has the opposite effect. Importantly, Box 1 below contends that EM USD debtors' creditworthiness is more sensitive to exchange rate dynamics than to US Treasury yields. Box 1 What Is More Imperative For EM FX Debtors: Exchange Rates Or Interest Rates? EM debtors with dollar debt are much more vulnerable to an appreciating dollar than to rising US interest rates.   Table 1 illustrates this point using the following hypothetical simulation: we consider a Brazilian debtor with $1,000 in debt with five years remaining to maturity, and a starting point exchange rate of 4 BRL per USD. Table 1A Hypothetical Simulation: FX Debt Burden Is More Sensitive To The Exchange Rate Than Borrowing Costs A Primer On EM USD Bonds A Primer On EM USD Bonds In our example, a 5% depreciation in local currency against the dollar boosts the overall debt burden by 200 BRL (please refer to row 2 of Table 1). This does not include the rise in local currency costs of interest payments. It reflects only the increased burden of the principal. An equivalent rise in debt servicing costs in local currency will require a 100-basis-point increase in US dollar borrowing costs. In other words, US dollar rates should rise by 100 basis points for interest payments to increase by BRL 200 over a five-year period (or $10 USD per year = 40 BRL per year), the time remaining to maturity. This simulation reveals that a 5% dollar appreciation versus the local currency is as painful as a 100 basis-point rise in US dollar rates and is more burdensome if the cost of coupon payments is accounted for. Given the elevated volatility of many EM currencies, there are higher odds of a 5% currency depreciation than a 100 basis-point rise in US bond yields. We therefore infer that EM FX debtors' creditworthiness is more sensitive to exchange rates than to US Treasury yields. Consequently, the trend in EM exchange rates versus the US dollar is much more important for EM credit spreads than fluctuations in US bond yields. As to the currency composition of EM FX debt, about 82% of EM external debt is in US dollar terms. As Chart 1 and 2 demonstrate, EM corporate and sovereign credit spreads correlate more strongly with EM exchange rates than with US bond yields. Chart 1EM Credit Spreads Tightly Correlate With EM Currencies EM Credit Spreads Tightly Correlate With EM Currencies EM Credit Spreads Tightly Correlate With EM Currencies Chart 2EM Credit Spreads Have A Loose Correlation With US Treasury Yields EM Credit Spreads Have A Loose Correlation With US Treasury Yields EM Credit Spreads Have A Loose Correlation With US Treasury Yields   Further, in the medium term (up to one year), the debt burden (debt-to-revenue or debt-to-GDP ratio) of firms and countries does not fluctuate much.1 Besides, interest payments do not change much either, especially for debtors with fixed-rate loans. Of the four components listed above, two of them – the debt burden and interest rates – do not change in the medium term. Therefore, the primary focus of EM credit investors in the medium term should be the other two variables - their revenues/economic growth and exchange rate fluctuations. The Outlook For EM Economic Growth… For EM sovereign issuers, government revenue used to service public debt oscillates with its business cycle. So do EM corporate revenues. On a related note, the business cycle analysis that we often present in our strategy reports is pertinent not only for EM equities but also for EM sovereign and corporate credit markets. The broad EM business cycle and EM sovereign and corporate spreads are driven by the following: Chart 3Growth In EM (ex-China, Korea, Taiwan) Is Weaker Than In DM Growth In EM (ex-China, Korea, Taiwan) Is Weaker Than In DM Growth In EM (ex-China, Korea, Taiwan) Is Weaker Than In DM 1. Each country’s monetary and fiscal policies as well as the health of the banking system. These drivers remain downbeat at present. As we argued in a recent report, the fiscal thrust will be negative in many EM economies this year. In EM ex-China, last year’s monetary easing was not fully transmitted to the real economy. This is because lending rates remain high (relative to the underlying growth potential of these economies) and banks lack the appetite to originate loans. Chart 3 illustrates that manufacturing PMIs in EM (ex-China, Korea, Taiwan2) are very subdued compared to DM manufacturing PMIs. 2. China’s imports, which are an important driver of the EM business cycle, are set to decelerate considerably. Chart 4 reveals that China’s credit and fiscal spending and broad money impulses foreshadow substantial weakness in Chinese imports. The Middle Kingdom’s credit and fiscal spending impulse signifies a new downturn in construction and traditional infrastructure spending (Chart 5, top panel). Consistently, the broad money impulse is heralding a rollover in raw material prices (Chart 5, bottom panel). Chart 4Chinese Imports Are Set To Slow Chinese Imports Are Set To Slow Chinese Imports Are Set To Slow Chart 5Construction And Raw Materials Are At Risk Due To A Credit Downtrend In China Construction And Raw Materials Are At Risk Due To A Credit Downtrend In China Construction And Raw Materials Are At Risk Due To A Credit Downtrend In China   A substantial chunk of the EM corporate USD bond universe is exposed to a slowdown in China’s “old economy”. Chinese property developers’ USD bonds account for 5% of Barclays’ EM corporate and quasi-sovereign bond index. Besides, China’s local government financing vehicles, SOEs and issuers representing the “old economy” also have a large weight (about 21%) in the EM corporate credit benchmark. Finally, EM resource companies (basic materials and energy), in turn, make up 16% of the same index (Chart 6). Chart 6Industry Composition Of Bloomberg Barclays’ EM Corporate And Quasi-Corporate Bond Index A Primer On EM USD Bonds A Primer On EM USD Bonds As a result, China’s total social financing impulse leads EM corporate credit spreads (the latter are shown inverted in the chart) and is presently pointing to widening credit spreads (Chart 7). 3. The US economy is less important to broader EM growth and, hence, to EM credit spreads. US domestic demand historically exhibited a low correlation with EM corporate excess returns (Chart 8). Chart 7China's Credit Cycle Poses Risks To EM Credit Markets China's Credit Cycle Poses Risks To EM Credit Markets China's Credit Cycle Poses Risks To EM Credit Markets Chart 8US Domestic Demand And EM Credit Markets: No Correlation US Domestic Demand And EM Credit Markets: No Correlation US Domestic Demand And EM Credit Markets: No Correlation   Many EM countries sell more to China than to the US. Exceptions are Mexico and oil producers. US oil demand is still vital to oil prices and, hence, to oil producing countries/companies. The ongoing economic boom in the US will have less boost to EM governments and corporate revenue growth than is generally perceived by the global investment community, except in Mexico and oil producing countries. Bottom Line: China’s business cycle will be slowing, and the rest of EM will continue experiencing very sluggish growth despite the US economic boom. The top panel of Chart 9 suggests that the relapse in EM manufacturing PMI heralds wider sovereign credit spreads. Similarly, declining EM net EPS revisions also point to widening corporate spreads (Chart 9, bottom panel). Chart 9EM Business Cycle Drives EM Credit Spreads EM Business Cycle Drives EM Credit Spreads EM Business Cycle Drives EM Credit Spreads … And Exchange Rates As discussed in Box 1 above, exchange rate fluctuations matter a great deal for debtors’ ability to service their foreign currency liabilities. Given that the overwhelming majority of EM foreign currency debt is denominated in USD, the outlook for EM exchange rates versus the US dollar is critical to EM credit markets. We thus have the following considerations with respect to EM currencies: EM exchange rate changes correlate with their sovereign and corporate credit spreads (Chart 1 above). Currency appreciation makes foreign debt servicing cheaper and reduces credit risk, while currency depreciation has the opposite effects. In turn, EM exchange rate swings correlate more with their own business cycle than with the US’s business cycle. Chart 10 shows that the EM manufacturing PMI explains most swings in EM currencies versus the greenback. Chart 10EM Currencies Oscillate With The EM Business Cycle EM Currencies Oscillate With The EM Business Cycle EM Currencies Oscillate With The EM Business Cycle As the US output gap shrinks, US interest rate expectations, including real rates, will rise. This will boost the value of the greenback over the next several months, especially in relation to currencies of countries where growth will be subdued or weakening. Overall, an impending slowdown in China and the ongoing US economic boom will boost the US dollar versus EM currencies. That, in turn, warrants wider EM sovereign and corporate credit spreads. The risk to this view is that US TIPS yields do not rise despite the very robust economy. In such a case, the US dollar will fail to rally. The lack of EM currency depreciation will in turn cap the upside in EM credit spreads. In such a case, investors will be better off staying positive on EM credit in absolute terms. EM Sovereign Credit: Cross Country Allocation Chart 11 depicts a tool to identify pockets of value among EM sovereign credits. On the X axis, we show a fundamental variable which is the country’s fiscal thrust this year minus its real (core inflation-adjusted) government local currency bond yield. On the Y axis, we plot current sovereign credit spreads for each individual country. A combination of more negative fiscal thrust and higher real government bond yields bodes ill for the outlook for nominal GDP and, hence, debt sustainability. This warrants wider sovereign credit spreads. Besides, a negative fiscal thrust and weak economic growth often produce a weak currency. When both fiscal and monetary policies are tight and cannot be relaxed, the exchange rate could act as a release valve and depreciate. The latter also heralds wider credit spreads. Chart 11 confirms that this reasoning works in reality. Countries like Brazil, Egypt and South Africa – where the fiscal thrusts are the most negative and/or real government bond yields are at their highest – trade at wider sovereign spreads. Chart 11Identifying Pockets Of Value In The EM Credit Space A Primer On EM USD Bonds A Primer On EM USD Bonds By contrast, countries like Poland and the Philippines – where the fiscal thrust is positive and/or real government local currency bond yields are at their lowest – enjoy tight sovereign credit spreads. Based on this diagram, investors should overweight countries in the north-east quadrant (Colombia, Mexico, Chile, South Africa, the Philippines and Egypt) and underweight those in the south-west quadrant (Brazil, Indonesia, Malaysia, Hungary and Poland). On this chart, Turkey is an outlier. At 500 basis points, its sovereign credit spread is wider than is suggested by its fundamental indicator (calculated as the fiscal thrust minus real government bond yield). The basis is that investors and analysts including us, believe that the nation’s low real interest rates are not sustainable and will produce another major downleg in its exchange rate, which will force its real bond yields higher. In brief, Turkey’s sovereign credit spreads will narrow only if authorities hike interest rates dramatically and tighten fiscal policy. Barring these policy adjustments, the lira will continue depreciating and sovereign spreads will widen. Investment Conclusions On March 25, 2021, we downgraded EM sovereign and corporate credit to underweight relative to US corporate credit (Chart 12). This a tactical downgrade for the next six months or so. The rationale is as follows: an economic boom in the US will bolster revenues of US corporates while China will slow and the rest of EM will post weak growth. Such a growth disparity between the US on the one hand and China/EM on the other hand will weigh on the relative performance of EM credit versus US corporate credit. In absolute terms, EM sovereign and corporate credit spreads will widen if US real bond yields rise, producing a rebound in the US dollar. Chinese corporate and quasi-corporate credit spreads have already been widening (Chart 13, top panel). Chart 12Underweight EM Credit Versus US Credit Underweight EM Credit Versus US Credit Underweight EM Credit Versus US Credit Chart 13Has The Rally In Chinese Offshore Credit Market Ended? Has The Rally In Chinese Offshore Credit Market Ended? Has The Rally In Chinese Offshore Credit Market Ended? Chart 14A Couple Of Indicators To Watch For Asia And EM Credit A Couple Of Indicators To Watch For Asia And EM Credit A Couple Of Indicators To Watch For Asia And EM Credit This has largely been due to two factors: (1) credit and regulatory tightening for property developers and the housing market weighing on bond prices of property developers (Chart 13, bottom panel); and (2) central government efforts to introduce credit and fiscal discipline among government-owned borrowers. These policies will persist, causing further repricing of credit risk for Chinese borrowers. In addition, the budding deceleration in China’s “old economy” will undermine the revenue growth of borrowers operating in this part of the economy, generating wider credit spreads. Relative performance of high-yield versus investment-grade credit has always been a coincident indicator for the direction of EM credit spreads. In emerging Asia, relative excess returns of high-yield corporates versus investment-grade ones has been drifting sideways (Chart 14, top panel). In broader EM, relative credit spreads between high-yield and investment-grade corporates are at a critical technical juncture (Chart 14, bottom panel). Presently, none of these indicators are sending a clear signal about the directions of excess returns and credit spreads in both emerging Asia and broader EM. At the moment, our sovereign credit overweights are Mexico, Colombia, Russia, Malaysia, the Philippines and Indonesia. Our underweights are Brazil, South Africa and Peru. This allocation differs slightly from the conclusions we derived from this analysis because we take into account more factors than those presented in Chart 11. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Excluding COVID- and GFC-type crises and following stimulus, the debt-to-GDP and debt-to-revenue ratios for the majority of sovereign and corporate borrowers do not change substantially within the space of a year. It is very rare for a company or government to become overindebted within a year or to reduce its debt dramatically within that time frame. The debt burden is a structural variable and it changes gradually over time. 2 Taiwan is referred to Taiwan, Province of China.   Equities Recommendations A Primer On EM USD Bonds A Primer On EM USD Bonds Currencies, Credit And Fixed-Income Recommendations

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Europe Is Behind The US, But On The Same Path Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Euro Area Hospitalizations Remain High, But Will Soon Decline Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise The Macro Data Continues To Positively Surprise The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve May 2021 May 2021 Chart I-4China's Current Contribution To Global Demand Is Strong China's Current Contribution To Global Demand Is Strong China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? Is Peaking Growth Momentum A Risk For Stocks? Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance May 2021 May 2021 US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Earnings Expectations Already Price In A Normalization In Services Activity Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning India's COVID-19 Situation Is Tragic, And Concerning India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks... Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks... Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last May 2021 May 2021 Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Leading Indicators Of China's Economy Are Pointing Down, Not Up Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels Chinese Interest Rates Have Already Returned To Pre-COVID Levels Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Emerging Markets Have Caused Global Ex-US Stocks To Underperform Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based EM's Underperformance Has Been Broad-Based EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Policy Rate Surprises Tend To Drive The Duration Call Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit May 2021 May 2021 In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates May 2021 May 2021 In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs May 2021 May 2021 Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs May 2021 May 2021 The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights The backdrop for global high-yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. With improving global growth taking over the reins from central bank liquidity as the primary driver of high-yield returns, we have decided to reassess the sources of value using some of our key indicators for junk bonds in the US and Europe. The US and euro area appear fairly evenly matched on our valuation metrics but euro area high-yield still offers good value on an absolute basis. We are therefore increasing our recommended allocation to overweight, matching our similar stance for US high-yield. Within the euro area, stay up in quality, favoring Ba-rated credit. Retail and consumer products are attractive bounce-back sectors as Europe emerges from lockdowns later this year. Feature Chart of the WeekCentral Bank Liquidity Has Driven High Yield Outperformance Central Bank Liquidity Has Driven High Yield Outperformance Central Bank Liquidity Has Driven High Yield Outperformance The past year has been excellent for global high-yield corporate bonds. Unprecedented monetary and fiscal stimulus in response to the COVID-19 economic shock and market rout helped rapidly lower credit spreads in the final three quarters of 2020. As the vaccine rollout picked up pace and the reopening trade began to dominate earlier this year, high-yield corporates continued to perform well despite defaults hitting a post-2008 high (Chart of the Week). An improving outlook for the global economy is highly supportive for lower-rated corporate debt from a fundamental perspective, even if that same pickup in growth will put pressure on policymakers to dial back monetary accommodation. Already, growth in major central bank balance sheets – a reliable leading indicator of high yield outperformance – is slowing, with corporate spreads approaching historically tight levels. Thus, we feel it is timely to assess valuation metrics in the largest high-yield markets of the US and Europe – and the implications for regional high-yield allocations - as economic growth takes over the reins from central bank liquidity as the primary driver of spread product performance. A Cyclical Reduction In Corporate Credit Risk In its recently published Global Financial Stability Report,1 the IMF noted that the COVID-19 shock has pushed up global nonfinancial corporate leverage, measured as debt relative to GDP, to historical highs (Chart 2). Some of that rise is due to companies ramping up debt issuance over the past year in response to supportive monetary policy and favorable financial market conditions. Yet according to the IMF, about half of the rise in global corporate debt-to-GDP ratios from Q4/2019 to Q3/2020 was attributable to sharply lower output. Now, with economic growth set to stage a strong rebound this year – the IMF is forecasting global real GDP growth of 6.0% in 2021 and 4.4% in 2022 - a rising denominator should result in corporate debt-to-GDP ratios stabilizing or even falling over the next couple of years. This will help maintain a positive backdrop for corporate spread product, even if central banks like the Fed turn less dovish later this year, as we expect Corporate interest coverage, using the Refinitiv Datastream bottom-up aggregates of individual company data, paints a similar cyclical picture (Chart 3). The absolute level of coverage ratios fell sharply in 2020, accelerating pre-pandemic downtrends that had already been in place in both the US and Europe. Since Q4/2019, however, interest expense actually fell very slightly in the US, meaning that of the 1.5 point fall in the interest coverage ratio, 1.3 points can be attributed to declining corporate earnings over that period. The picture was also lopsided in the euro area, with 2.5 points of the 2.8 point decline in interest coverage over that same period attributable to falling profits. Chart 2Rising Leverage Is Not Just A Debt Story Rising Leverage Is Not Just A Debt Story Rising Leverage Is Not Just A Debt Story Chart 3Falling Earnings Are Responsible For The Decline In Interest Coverage Falling Earnings Are Responsible For The Decline In Interest Coverage Falling Earnings Are Responsible For The Decline In Interest Coverage Rapid improvements in economic growth momentum, fueled by reopening economies and increased fiscal stimulus (especially in the US), should lead to a cyclical rebound interest coverage ratios in both the US and Europe in 2021 and 2022. Bottom Line: The backdrop for global high yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. A Trans-Atlantic Comparison Of High-Yield Bond Valuations Chart 4Our Relative Overweight On US HY Has Been A Success Our Relative Overweight On US HY Has Been A Success Our Relative Overweight On US HY Has Been A Success Since March of last year, we have maintained a recommended overweight stance on US high-yield versus European equivalents (Chart 4). That was originally a relative central bank play with the Fed including US high-yield in its corporate bond buying program, in contrast to the ECB that was only buying investment grade debt. Our relative regional allocation on high-yield corporates has worked out well, with the US outperforming the euro area by 3.9 percentage points (in excess return terms versus duration-matched government debt) since the pandemic peak in credit spreads last March. Today, with high-yield spreads back near historical tight levels and the momentum of excess returns starting to peak, a forward-looking reevaluation of our US versus Europe high-yield recommendation along value grounds is in order. To conduct our reassessment of value, we look at five key areas: default-adjusted spreads; 12-month breakeven spreads; volatility-adjusted spreads; credit quality curves; and, lastly, the relative carry offered by high-yield corporates in currency-hedged and unhedged terms. Default-Adjusted Spreads As discussed earlier in the report, fiscal and monetary support have helped stave off the worst for high-yield corporates on both sides of the Atlantic, with default rates spiking far less than the amount implied by the collapse in year-over-year GDP growth (Chart 5). Forecasts for 2021 are sanguine—Moody’s expects the trailing 12-month high yield default rate to reach 4.2% in the US and 2.6% in the euro area in 2021, in line with the IMF’s sharp upward revision to growth forecasts for both regions. The outlook for default-adjusted spreads, which look at the index option-adjusted spread (OAS) net of realized default losses, is much more positive in the euro area however, given that they have a much more attractive “starting point”. The realized default-adjusted spread in the euro area was already inching into positive territory last year, as opposed to the deeply negative spread in the US (Chart 6). This alone makes it much more likely that euro area high-yield will deliver a positive return net of default losses. Chart 5The Default Picture Is Expected To Improve The Default Picture Is Expected To Improve The Default Picture Is Expected To Improve Chart 6Euro Area Spreads Are More Attractive On A Default-Adjusted Basis Euro Area Spreads Are More Attractive On A Default-Adjusted Basis Euro Area Spreads Are More Attractive On A Default-Adjusted Basis In addition, the potential range for default-adjusted spreads (combining default rates and recovery rates, see the shaded boxes in the chart) is much narrower in the euro area given the lower post-crisis volatility in default rates in that region, making outcomes in the euro area far less uncertain than in the US. Volatility-Adjusted Spreads Chart 7Falling US Spreads Have Overshot The Level Implied By Equity Volatility Falling US Spreads Have Overshot The Level Implied By Equity Volatility Falling US Spreads Have Overshot The Level Implied By Equity Volatility Another way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX and the European VSTOXX indices. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. The global rally in riskier credit has helped push down volatility-adjusted spreads for both regions, making them expensive relative to the historic mean (Chart 7). However, the divergence between volatility and high-yield spreads is much more pronounced in the US, where the volatility-adjusted spread, currently at all-time lows and 1.8 standard deviations below the mean, appears much less attractive. In contrast, while the euro area measure is still within one standard deviation of the mean and has room to fall further, as it did in 2007. 12-Month Breakeven Spreads To look at valuations in high yield corporates relative to history, we turn to our 12-month breakeven spread metrics. These measure how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus a duration-matched position in government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. On this basis, there seems to be a bit more value in US high-yield spreads, with the 12-month breakeven at the 32nd percentile compared to the 18th percentile ranking for European high-yield. Both markets are not cheap on this metric, though, with the lion’s share of cyclical spread compression having already been realized (Chart 8). This additional value in the US is concentrated in the lower-quality tiers, with B-rated US HY looking most attractive (Chart 9). Chart 8US And Euro Area High-Yield Breakeven Spreads US And Euro Area High-Yield Breakeven Spreads US And Euro Area High-Yield Breakeven Spreads Chart 9All Credit Tier Breakeven Valuations Are In the Bottom Half Relative To History A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe Credit Quality Curves To further inform our decision on value across credit tiers in the US and Europe, we look at credit quality curves, which measure the incremental spread pick-up earned from moving down to lower credit tiers. For example, we look at the spread differential between B-rated and Ba-rated high-yield bonds within the US or Europe. When making the comparisons, we adjust the spreads to account for duration differences between credit tier sub-indices and the overall regional high-yield index. This adjusts for slightly lower index durations as we move down in quality.2 Our colleagues at BCA Research US Bond Strategy have pointed out that the spread pickup earned from moving out of US Baa-rated bonds into Ba-rated bonds is elevated compared to typical historical levels.3 Credit quality curves in the euro area tell a similar story (Chart 10). The spread pickup from moving into Ba-rated credit is slightly higher in the euro area on a cross-country basis while there is a more attractive pickup in the US from moving further down in quality. Chart 10US & European HY Credit Quality Curves US & European HY Credit Quality Curves US & European HY Credit Quality Curves Chart 11Euro Area Caa-Rated Spreads Have Room To Fall To Pre-COVID Lows A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe As quality curves have compressed across the board, we can also use the pre-COVID lows in these series as an anchor for how much more narrowing we could see (Chart 11). On that basis, there seems to be a bit more value left in the top two tiers of US high yield while there is more juice left in the euro area Caa-rated minus B-rated spread. The Caa-B spread differential is now quite expensive for the US, sitting -140bps below its pre-COVID low, a reflection of yield-chasing behavior by risk-seeking investors in an easy monetary policy environment. As the Fed begins to take its foot off the monetary accelerator within the next 6-12 months, as we expect, this credit tier is also most vulnerable to a repricing of default risk. Index Yield-To-Maturity Chart 12Junk Index Yields At All Time Lows Junk Index Yields At All Time Lows Junk Index Yields At All Time Lows The hunt for yield by fixed income investors has driven down the index yield on lower-quality credit to all-time lows in both the US and euro area (Chart 12). This dynamic has played out at a time when falling interest rate differentials between the two regions have cut down the cost of hedging US dollar (USD) exposures into euros (or, alternatively, reduced the gain from hedging euro exposures into USD). Importantly, this reduction in the gains/losses from currency hedging allows for a more honest assessment of the relative attractiveness of yields on lower-rated corporates in the US and Europe, reflecting compensation for taking credit risk rather than currency risk. With the backdrop for spread product looking positive, it is worth considering the simple carry over a twelve-month period for holding high-yield debt, in both USD-hedged and unhedged terms (Chart 13). For the overall index and the Ba-rated tier, the US dominates completely, with investors in the euro area better off holding US credit even after paying the currency hedging cost. This dynamic is flipped at the B- and Caa-rated tiers, with euro area credit appearing dominant. Chart 13US Ba-Rated Debt Is Dominant On A Carry Basis A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe An Additional Point On High-Yield Sectors Sector composition will also be an important driver of high-yield returns going forward. In the April 2021 Global Financial Stability report, the IMF noted that global high-yield defaults in 2020 were concentrated in sectors most affected by the pandemic. On a relative basis, the US high-yield index appears more heavily weighted towards those sectors – a picture that becomes even more focused if Energy, which is the largest industry group in US high-yield, is considered as a pandemic-stricken industry (Chart 14). However, the euro area does have a slightly larger tilt towards the hard-hit Retail sector. Chart 14Oil And Gas Was Hardest-Hit In 2020 A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe An important implication is that the sectors that suffered the most in 2020 are also the ones most poised for a snapback this year as economies reopen and growth recovers. One way to approach this from a relative valuation perspective is to look at the relative industry-level cross-country spreads between the US and Europe, compared to the change in global defaults by sector from 2019 to 2020 (Chart 15). Chart 15Sectors That Saw Rising Defaults In 2020 Are Poised For A Rebound A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe Sectors that saw a moderate-to-high number of defaults last year, such as Retail and Consumer products, offer higher spreads in the euro area. These will also be the sectors to benefit the most from a consumption rebound as Europe exits lockdowns. On the other hand, US spreads are more attractive than European spreads for the Media and Transportation sectors that saw a big increase in defaults in 2020. Importantly, while the US Energy sector also looks more relatively attractive on that basis, much of a post-COVID recovery has already been priced in, with US high-yield energy spreads below pre-pandemic lows. Investment Conclusions Having looked at our suite of valuation metrics, euro area and US high-yield appear quite evenly matched. On a default and volatility-adjusted basis, spreads in the euro area appear to offer more value while US high-yield largely wins out on a breakeven spread and carry basis. Thus, the case for favoring US high-yield over European equivalents is no longer as compelling as it has been for much of the past twelve months. We are therefore taking profits on our long-held recommended overweight stance on US high-yield versus European high-yield. We are implementing this change by upgrading our strategic euro area high yield allocation to overweight (4 out of 5), which matches our similar overweight recommended tilt for US high-yield (see table on page 15). Within our model bond portfolio, we are “funding” that upgrade by reducing the size of our recommended overweight exposure to core European sovereign debt in Germany and France (see the model bond portfolio tables on pages 13-14). On the margin, this decision also positions us favorably with regards to the consumption driven H2/2021 recovery in euro area economies highlighted by our colleagues at BCA Research European Investment Strategy.4 Within European credit, we recommend staying up in quality, favoring the Ba-rated tier as lower quality tranches do not offer adequate compensation for the increased credit risk. Bottom Line: Rebounding global growth will help maintain a favorable backdrop for global high yield credit. The US and euro area look evenly matched on our valuation metrics, but there is still good value on offer in the euro area on an absolute basis. Increase allocations to euro area high-yield, favoring the Ba-rated credit tier and Retail and Consumer Products industries, in particular. Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1https://www.imf.org/en/Publications/GFSR/Issues/2021/04/06/global-financial-stability-report-april-2021 2 Please see BCA Research US Bond Strategy Report, "Ba- Rated Bonds Look Best", dated February 9, 2021, available at usbs.bcaresearch.com. 3 Note that this adjustment is made to facilitate more accurate comparisons within the credit tiers of the high-yield universe. No such adjustment is made to the Baa-rated credit spread, which is higher-quality investment grade and therefore not part of the high-yield universe. 4 Please see BCA Research European Investment Strategy Special Report, "A Temporary Decoupling", dated April 5, 2021, available at eis.bcaresearch.com. Recommendations A Comparative Look At High-Yield Valuations In The US And Europe A Comparative Look At High-Yield Valuations In The US And Europe Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Investors’ hunt for yield over the past few years led them to view leveraged loans as an attractive investment. Characterized by low volatility and attractive risk-adjusted returns, leveraged loans can add value to a portfolio. Leveraged loans tend to outperform their fixed-rate counterparts (for example, high-yield bonds) in an environment of rising rates and an attractive valuation starting point. Only the former criterion is true currently. Risks do exist, however. The increasing share of covenant-lite issues, and rising leverage in the corporate sector are of particular concern. Over the next 6-to-12 months, we do not expect rates to rise substantially, making the asset class somewhat unappealing in the short term. The longer-term outlook is attractive nevertheless, since rates are likely to rise as inflation picks up over the coming years. Feature In today’s environment of ultra-accommodative monetary policy, including low interest rates, and unattractive valuations for fixed-income risk assets, investors have no option but to look beyond conventional fixed-income instruments and dial up their risk appetite. In this Special Report, we run through the mechanics of the leveraged loan market. We analyze historical risk-return characteristics and compare leveraged loans to other assets. We also assess their performance during periods of financial-market stress as well as periods of rising rates and inflation. Finally, we discuss the risks associated with owning leveraged loans. What Are Leveraged Loans? Leveraged loans are a type of syndicated loan made to sub-investment-grade companies. Generally, these firms are highly indebted, with low credit ratings. A syndicated loan is structured, arranged, and administered by one or several commercial or investment banks.1 The majority of these loans are senior secured loans and are based on a floating rate, mostly LIBOR plus a premium (more than 150-200 bps) to account for their riskiness as well as to attract non-bank institutional investors. The interest rates on these loans adjust at regular intervals to reflect changes in short-term interest rates; this constitutes a benefit for investors worried about rising rates. Definitions vary when it comes to categorizing leveraged loans. Some group them based on the borrower’s riskiness and their credit rating. Others consider leverage metrics such as debt-to-capital and debt-to-EBITDA. Other classifications look at the spread at issuance or the purpose of the fund raising, which can include funding mergers and acquisitions (M&A), leveraged buyouts (LBOs), refinancing existing debt, or general funding. Over the past five years, approximately 50% of US leveraged loans issued were for refinancing purposes (Chart 1, panel 1). Within the three categories, LBO financing is deemed the riskiest, and this is reflected in its higher spread (Chart 1, panel 2). The leveraged-loan market became particularly popular in the mid-1980s as M&A activity was soaring (Chart 2). Chart 1Uses Of Leveraged Loans Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 2The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth There are two common types of financing facilities:2 Term loans: An agreement to borrow a sum of money that is paid back over a certain payment schedule. These loans are mainly provided by non-bank entities. Revolving facilities: A type of loan that can be repeatedly drawn upon and repaid. These loans are mostly originated and held by banks. Estimates for the size of the leveraged-loan market vary depending on which criteria and definitions are used. The size of the leveraged-loan market, following rapid growth since the beginning of the past decade, is estimated to be over $1.2 trillion as of Q2 2020.3 While this represents only a small portion of overall corporate debt (it is only 15% the size of the corporate bond market), the interconnections between key market participants and the role of banks in the market has caught the attention of several regulators such as US Treasury Secretary Janet Yellen, debt investors such as Howard Marks, and international institutions such as the Bank For International Settlements (BIS). The focus of their concerns has been on the declining credit standards for leveraged loans – particularly, the increase in issuance of “covenant-lite” (cov-lite) loans, inconsistent definitions of EBITDA in loan agreements, the growth in use of “EBITDA add backs”,4 and the accuracy of leveraged-loan ratings.5 We discuss some of those concerns in the Risks section. Table 1Risky Loans Are Mainly Held By Non-Bank Entities… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Over the past several decades, the role of banks in providing capital to the leveraged loan market has shrunk and has been replaced by non-bank lenders such as mutual funds, hedge funds, insurance companies, and asset managers.6 Data by the Shared National Credit (SNC) program7 shows that non-bank entities in the US now hold close to 83% of all non-investment-grade term loans (Table 1). Moreover, estimates by the Bank of England8 (BoE) show that a quarter of the global stock of leveraged loans (which it estimates at close to $3.4 trillion) is held through collateralized loan obligations (CLOs)9 and approximately half is owned by non-bank institutions. In turn, those non-bank institutions hold a significant portion of CLOs – particularly the riskier tranches. This is not to say that banks are not exposed to leveraged loans. But banks predominantly invest in the highest, AAA, tranche of CLOs, and investment-grade loans.10 Riskier-rated loans are held by CLOs, mutual funds, and other lenders such as hedge funds (Chart 3).11 Chart 3…Particularly Those Rated Below BB Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Historical Risk And Return Chart 4Leveraged Loans' Relative Performance Moves With Interest Rates Leveraged Loans' Relative Performance Moves With Interest Rates Leveraged Loans' Relative Performance Moves With Interest Rates Since 1997, leveraged loans12 have returned an annualized 4.9%, 25 basis points higher than US Treasurys and approximately 100 and 200 basis points less than US investment-grade and high-yield bonds, respectively. They have underperformed US equities by an annualized 400 basis points over the same period. Declining rates over the past two decades are the most likely reason leveraged loans have underperformed their fixed-rate counterparts. The relative performance of leveraged loans to investment-grade bonds has closely tracked the trajectory of Treasury yields (Chart 4). While the case is not as clear for relative performance against high-yield bonds, the trend is similar. However, on a risk-adjusted return basis, due to reduced volatility, leveraged loans did outperform both equities and high-yield corporate bonds (Table 2). We nevertheless think that volatility is likely understated given the elevated kurtosis. The larger negative skew and excess kurtosis could indicate higher probabilities of large negative returns (Chart 5).   Table 2Historical Risk-Return Characteristics Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 5Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Why Should Investors Consider Leveraged Loans? Chart 6Rising Rates Support Higher Return From Leveraged Loans... Rising Rates Support Higher Return From Leveraged Loans... Rising Rates Support Higher Return From Leveraged Loans... Our US bond strategists have showed that the odds of leveraged loans outperforming fixed-rate high-yield bonds increase when certain criteria are in place – particularly when valuations are tilted in loans’ favor, and Treasury yields are rising.13 Only the latter criterion is true currently. Year-to-date, leveraged loans have returned 2.2%, higher than the -3.2%, -3.4%, 1.6%, and -3.4% from US Treasurys, investment-grade bonds, high-yield bonds, and emerging markets sovereign debt, respectively (Chart 6). During the same period, Treasury yields rose by 65 basis points. We find that periods of rising Treasury yields are associated with increased flows into the asset class (Chart 7). More interestingly, leveraged loans outperform junk bonds when Treasury yields rise faster than what is discounted in the forwards curve over the following 12 months (Chart 8). Chart 7...As Well As Increased Fund Flows ...As Well As Increased Fund Flows ...As Well As Increased Fund Flows Chart 8Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve     This does not seem to be the case today, however, with the 5-year, 1-year forward about 40 basis points higher than the current 5-year Treasury yield. This is in line with our view that rates are unlikely to rise substantially over the next 6-to-12 months. Inflation, beyond a temporary spike over the next few months, should remain subdued, at least until employment is back to a level which would put upward pressure on wages. This is unlikely before 2023. It is also important to consider the potential trajectory of monetary policy as well as changes in long-term yields. The Fed, through its dot plot, is signaling no increase in the Fed Funds Rate before 2024, but the market is becoming worried about inflationary pressures and pricing in an earlier Fed hike. We believe it unlikely that the Fed will raise rates ahead of what the market expects, unless the labor market returns to “maximum employment” over the next 12 months. The yield on leveraged loans has been lower than on high-yield bonds for most of the period we have data for, except early 2020. Given leveraged loans’ senior position in a firm’s capital structure, it makes sense that their yields are lower. Additionally, the sector composition of the two markets plays a role: Leveraged loans are more exposed to the Technology and Communications sectors and have a limited allocation (averaging 1% over the past seven years) to the Energy sector, unlike high-yield, fixed-rate bonds (where the weight of Energy has averaged 13%) (Chart 9). This was mostly evident when the yield differential collapsed to below -3% during the 2014/2015 oil crash (Chart 10). Chart 9Leveraged Loans’ Sector Weightings Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 10Loan Spreads Are Not Looking Attractive Loan Spreads Are Not Looking Attractive Loan Spreads Are Not Looking Attractive Chart 11Recent Investor Demand Pushed Up Leveraged Loan Prices Recent Investor Demand Pushed Up Leveraged Loan Prices Recent Investor Demand Pushed Up Leveraged Loan Prices The yield differential has, however, been trending upwards since then, and at current prices, upside may be limited. The recent surge in investor demand has pushed down yields on newly issued leveraged loans, moving the average bid price of leveraged loans above its pre-pandemic high (Chart 11). In the next section, we analyze how leveraged loans have behaved during recessions and other periods of financial market stress.   Financial Market Stress Performance In Crises Given the index’s short history, we are able to cover only the past three recessions (the dot-com bubble bust, the Global Financial Crisis (GFC), and the COVID-19 recession). We also look at the 2013 Taper Tantrum and the 2014/2015 oil price shock. In all cases, leveraged loans fell and subsequently recovered along with other fixed-income asset classes. The Taper Tantrum was the most favorable for leveraged loans: 10-year Treasury yields rose by 100 basis points over four months (Chart 12). Table 3 shows that periods of rising rates are a better environment for leveraged loans than those of declining rates. We also looked at a period of Fed tightening and easing cycles – although the timing of easing cycles overlaps with, recessions, dragging down the performance of leveraged loans. We also assess the impact of inflation on leveraged loans using the framework from our Special Report on inflation hedging,14 which decomposed inflation into four quartiles/regimes: Inflation levels below 2.3%, between 2.3% and 3.3%, between 3.3% and 4.9%, and above 4.9%. We add periods of decreasing inflation to our analysis. We note, however, that there was only one period where inflation was over the 4.9% threshold. Chart 12Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress   Table 3Leveraged Loans’ Performance During Different Rate Cycles… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Table 4…And Inflation Regimes Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? During periods in the first and second inflation quartiles, leveraged loans, in absolute terms, had the highest average annualized returns, 8.1% and 10% respectively. This makes sense since in those regimes, policy rates are low and bond yields begin to rise given robust growth. Leveraged loans, however, underperformed fixed-rate bonds during those periods. Inflation above 3.3% represents an environment in which the economy begins to overheat and growth to falter. This regime saw leveraged loans outperform high-yield bonds by an annualized 1.5%. Periods of declining inflation also showed moderately positive annualized returns for leveraged loans (Table 4).   Risks Chart 13Corporate Health Has Worsened... Corporate Health Has Worsened... Corporate Health Has Worsened... The growth of the leveraged loans market reflects multiple trends but, most importantly, a broad increase in corporate leverage, driven by a decline in interest rates and increasing availability of cheap financing. The debt-to-asset ratio of nonfinancial businesses, a gauge of corporate leverage, is at a 20-year high (Chart 13, panel 1). This raises concerns about the overall health of the corporate sector – particularly firms’ ability to service their debt – since the median interest coverage ratio is near a level last seen during the GFC. This measure is even negative for companies within the 25th percentile, meaning companies in that bucket lack funds to maintain their interest payments (Chart 13, panel 2). Trends in the leveraged loan market paint a similar picture. The share of newly issued loans by the most highly levered firms – those with a debt-to-EBITDA ratio of 6x or higher – has reached new highs, hitting 37% of new loans in Q3 2020 (Chart 14). Chart 14…Even For Leveraged Lending Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 15Cov-Lite Issuances Make Up Almost 80% Of New Issuances Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? The providers of capital are partly to blame. Even with credit standards deteriorating, firms looking for capital were mostly able to find it. The share of cov-lite structures – loans that lack the protective covenants found in traditional loans – continues to grow and now comprises almost 80% of new issuance (Chart 15). Cov-lite loans typically do not have any maintenance covenants, requirements to maintain certain ratios such as leverage or interest-coverage ratios.15 Instead, they feature incurrence covenants which have to be met only if the issuer wants to take particular actions, such as taking on more debt.16 This loosening of credit terms is mostly a function of increased demand, particularly by CLO buyers and other non-bank institutional investors, in an environment of low yields. Some have even warned that vulnerabilities in the leveraged-loan market could cause disturbance to the overall financial system. Particularly, memories of the GFC and worries about the “originate-to-distribute” model – whereby banks originate loans but retain only a fraction on their balance sheets – have led some observers to suggest this could all lead to a risky expansion of credit, and trigger a new financial crisis. Chart 16Leveraged Loans Have Higher Average Credit Ratings… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? We do not share this skepticism. Banks’ exposure to leveraged loans is mainly via the highest tranches of CLOs. Banks’ liquidity requirements have increased since the GFC, and therefore contagion should be minimal in the event of problems in the loan market. A recent report by the US Government Accountability Office (GAO) did not find evidence that leveraged lending presented a significant threat to financial stability.17 Additionally, almost all leveraged loans are first lien, they have a senior secured position in the capital structure, higher average credit ratings than high-yield bonds (Chart 16), and lower default rates (Chart 17). Moreover, their five-year average recovery rate of 63% tops the 40% of senior unsecured bonds (Chart 18). Chart 17...Lower Default Rates... ...Lower Default Rates,... ...Lower Default Rates,... Chart 18...And Higher Recovery Rates Than High-Yield Bonds ...And Higher Recovery Rates Than High-Yield Bonds ...And Higher Recovery Rates Than High-Yield Bonds   Conclusion In a period of ultra-low interest rates and stretched valuations for risk assets, leveraged loans have emerged as an interesting asset class for investors. Due to lower volatility, leveraged loans have historically produced higher risk-adjusted returns than fixed-rate high-yield bonds. However, volatility is likely understated given elevated levels of kurtosis. Historically, rising Treasury yields and an attractive valuation starting-point provided a signal for leveraged loans’ outperformance. Only one of those two criteria are currently in place. In the next 6-to-12 months, we do not believe rates will rise substantially, making this asset class somewhat unattractive in the short term. The longer-run outlook for leveraged loans, however, is attractive. As inflation, and therefore rates, rise over the next two-to-three years, a moderate allocation to leveraged loans might be a useful hedge for investors.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1 Please see “LCD Loan Primer – Syndicated Loans: The Market and the Mechanics,” S&P Global Market Intelligence. 2 Please see “Leverage Lending FAQ & Fact Sheet,” SIFMA, February 2019. 3 Please see “Federal Reserve Financial Stability Report,” November 2020. 4 “EBITDA add backs” add back expenses and cost savings to earnings and could inflate the projected capacity of the borrowers to repay their loans. 5 Please see Todd Vermilyea, “Perspectives On Leveraged Lending,” The Loan Syndications and Trading Association 23rd Annual Conference, New York, October 24, 2018. 6 Please see “Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, Chapter 1,” IMF, April 2019. 7 The SNC Program is an interagency program designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions. The SNC Program is governed by an interagency agreement among the three federal bank regulatory agencies - the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office Of the Comptroller Of The Currency (OCC). 8 Please see “Financial Stability Report,” Bank of England, August 2020. 9 CLOs are asset-backed securities issued by a special purpose vehicle which acquire a portfolio of leveraged loans. 10 Please see “Turns Out Leveraged Loans Aren’t a Systemic Risk After All,” Bank Policy Institute, February 8, 2020. 11 Please see Seung Jung Lee, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, “The U.S. Syndicated Term Loan Market: Who holds what and when?”, November 25, 2019. 12 For the purpose of this report, we use the S&P/LSTA Leveraged Loan Index, which tracks the market-weighted performance of US dollar-denominated institutional leveraged loan portfolios. 13 Please see US Bond Strategy Report, “The Price Of Safety,” dated January 27, 2015. 14 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 15 Please see Eric Goodison And Margot Wagner, Paul, Weiss, Rifkind, Wharton & Garrison Llp, “Covenant-Lite Loans: Overview,” August 2019. 16 Please see Scott Essexx, Alexander Ott, Partners Group, “The Current State Of The Leveraged Loan Market: Are There Echoes Of The 2008 Subprime Market?”, March 2019. 17 Please see “Financial Stability: Agencies Have Not Found Leveraged Lending To Significantly Threaten Stability But Remain Cautious Amid Pandemic,” United States Government Accountability Office, December 2020.

Highlights Duration: The pace of rate hikes currently priced into the market is reasonable. However, we see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: MBS remain unattractive compared to other US spread products. But within an underweight allocation to MBS, an up-in-coupon bias makes sense. Inflation: Year-over-year CPI inflation was pushed higher by base effects in March, but the report also showed evidence of mounting inflationary pressures beyond simple base effects. Feature After a sizeable drop last Thursday, Treasury yields are now significantly off their recent highs. The 10-year Treasury yield peaked at 1.74% on March 31st but ended last week at only 1.59%. What makes the drop puzzling is that yields are down despite a string of very strong US economic data (Chart 1). This recent development bears a resemblance to the famous 2004/05 bond conundrum when Fed Chairman Alan Greenspan struggled to understand why long-maturity Treasury yields were falling even as the Fed lifted short rates.1 Today, investors are also struggling to understand why long-maturity Treasury yields are falling, only this time the “conundrum” is that they are falling in the face of strong economic data. From our perch, both conundrums have the same answer: The market has already discounted a lot of the news. On June 29th, 2004 – the day before the first rate hike of that cycle – the overnight index swap (OIS) curve was priced for 243 bps of Fed rate hikes for the following 12 months. The Fed went on to deliver 200 bps of rate hikes during that timeframe, slightly less than the market expected. In that environment it is entirely consistent that bond yields should fall (Chart 2). Chart 1Yields Down On Strong Data Yields Down On Strong Data Yields Down On Strong Data Chart 2The 2004/05 Bond Conundrum The 2004/05 Bond Conundrum The 2004/05 Bond Conundrum Today, the OIS curve is priced for the Fed to lift rates off the zero bound in December 2022 and for a total of 86 bps of rate hikes by the end of 2023 (Chart 3). Given the Fed’s new Average Inflation Targeting regime, this sort of rate hike cycle will only be achieved if there is a very strong US economic recovery. The incoming US data are so far confirming that narrative but haven’t been strong enough to move rate expectations even higher. Chart 3Market Priced For December 2022 Liftoff Market Priced For December 2022 Liftoff Market Priced For December 2022 Liftoff As we wrote in last week’s report, we think that the market’s current rate hike expectations look reasonable.2 However, we see a meaningful risk that they could move higher in the coming months as the rapid US economic recovery continues and the Fed starts to back away from its extremely dovish messaging. Chart 4US Will Hit 75% Vaccination Well Before September US Will Hit 75% Vaccination Well Before September US Will Hit 75% Vaccination Well Before September For example, Fed Chair Jay Powell has said repeatedly that it is too soon to talk about tapering the Fed’s asset purchases. We worry, however, that this tone might be giving investors a false sense of security. If the economic recovery continues at its current pace, we fully expect the Fed to start talking about tapering this year and to begin the process either by the end of 2021 or in early 2022. Last week, St. Louis Fed President Jim Bullard said he would be comfortable starting discussions about tapering when 75%-80% of the US population has been vaccinated. We estimate that if vaccinations continue at a linear pace, we will hit 75% vaccination by September (Chart 4). Given the exponential trend in vaccinations so far, we are likely to reach 75% well before September. The bottom line is that we see the pace of rate hikes currently priced into the market as reasonable. However, we also see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: Stay Up In Coupon Unsurprisingly, the reflation trade has been beneficial for risk assets. Within US fixed income, spread products have generally outperformed Treasuries since bond yields bottomed last August. However, certain spread sectors have fared better than others. Agency Mortgage-Backed Securities, for example, have not done that well. Conventional 30-year Agency MBS have only outperformed a duration-matched position in Treasury securities by 73 bps since bond yields bottomed on August 4th, 2020 (Chart 5). This compares to 446 bps of outperformance for Aaa-rated corporates, 342 bps of outperformance for Aa-rated corporates (Chart 5, panel 2) and 232 bps of outperformance for Agency CMBS (Chart 5, panel 3). Only notoriously low-risk Aaa-rated consumer ABS have delivered less outperformance than Agency MBS (Chart 5, bottom panel). While Agency MBS have not performed well overall, certain segments of the coupon stack have delivered decent excess returns. Specifically, higher coupon MBS have performed much better than low coupon MBS during the recent back-up in yields. Since last August, 4% coupon MBS have outperformed duration-matched Treasuries by 176 bps and 4.5% coupons have outperformed by 257 bps. Meanwhile, 2.5% coupons have underperformed by 10 bps and 3% coupons have underperformed by 15 bps (Chart 6). Chart 5Spread Product Performance Since Trough In Bond Yields Spread Product Performance Since Trough In Bond Yields Spread Product Performance Since Trough In Bond Yields Chart 6Favor Premium Coupons In Rising Rate Environment Favor Premium Coupons In Rising Rate Environment Favor Premium Coupons In Rising Rate Environment The divergent performance between high and low coupons is easily explained by the risk characteristics of those bonds. Looking at the difference between the 2.5% and 4% coupons, for example, we see that the 2.5% coupons have significantly higher duration and significantly lower convexity (Chart 6, bottom 2 panels). The higher duration means that rising yields hurt 2.5% coupons more and the lower convexity means that rising yields will cause the gap between 2.5% coupon duration and 4% coupon duration to widen further. In short, a rising yield environment is terrible for low-coupon MBS. Conversely, high duration and low convexity are desirable attributes in a falling yield environment. If bond yields fall meaningfully going forward, then low-coupon MBS will outperform the high coupons. Chart 7A shows how option-adjusted spread (OAS) varies with duration across the conventional 30-year Agency MBS coupon stack. We see that the lowest coupons have the highest durations and the lowest OAS. Premium coupons have low durations and high OAS. Chart 7AAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration A New Conundrum A New Conundrum Chart 7B shows how OAS varies with convexity across the coupon stack. Here we see that the 2%, 2.5% and 3% coupons have the most negative convexities. This makes sense as those coupons are closest to the current mortgage rate of 3.04%. A further increase in the mortgage rate would make those coupons less likely to refinance, causing durations to extend meaningfully. Conversely, a drop in the mortgage rate would lead to greater refinancings for those coupons, causing durations to shorten. Notice that 1.5% coupon MBS have relatively high convexity. This is because refinancing is already unattractive for those bonds, and the duration of the 1.5% index has already extended. Chart 7BAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity A New Conundrum A New Conundrum Given our view that US Treasury yields will be flat-to-higher for the next 6-12 months, we recommend an up-in-coupon bias within Agency MBS. Specifically, the 2%, 2.5% and 3% coupons have the most scope for duration extension in a rising yield environment and should be avoided. The 4% and 4.5% coupons, on the other hand, are less negatively convex and are better able to weather the storm of rising bond yields. In a flat bond yield environment, the best performing coupons are likely to be those with the widest OAS. This makes the 4% and 4.5% coupons look much more attractive than the 1.5% coupons, even though they have similar convexities. Overall, we recommend owning the 4% and 4.5% coupons within the conventional 30-year Agency MBS coupon stack and avoiding the 2%, 2.5% and 3% coupons. One final point worth making is that we also continue to recommend an underweight allocation to MBS within a US bond portfolio. That is, though higher coupon MBS look better than the low coupons, the entire sector looks unattractive compared to alternatives like consumer ABS, Agency CMBS and even investment grade corporate bonds. Chart 8 shows a version of our Excess Return Bond Map, a visual guide that is useful for quickly assessing the risk/reward trade-off between different US spread products.3 The Map shows OAS as a measure of expected return on the Y-axis, and a proprietary risk measure called the “Risk Of Losing 100 Bps” on the X-axis. A higher number on the X-axis indicates less risk of losing 100 bps and vice-versa. Chart 8Excess Return Bond Map A New Conundrum A New Conundrum Our Bond Map makes it clear that only 4% and 4.5% coupon MBS come close to offering a risk/reward balance that is comparable to other spread sectors. MBS coupons below 4% offer far too little expected return given the amount of risk. Bottom Line: Remain underweight MBS within a US bond portfolio, but favor 4% and 4.5% coupons over 2%, 2.5% and 3% coupons within the Agency MBS coupon stack. March CPI More Than A Base Effect It was well known heading into last week’s March CPI release that the year-over-year inflation number was going to be very strong. This is due to base effects that will persist through to the end of May. That is, 12-month inflation is bound to rise as the negative monthly inflation prints from March, April and May 2020 fall out of the 12-month rolling sample. Year-over-year inflation numbers did indeed rise sharply in March (Chart 9). 12-month headline CPI jumped from 1.68% to 2.64% and 12-month core CPI increased from 1.28% to 1.65%. Base effects exert less influence over the trimmed mean CPI, and that index rose only from 2.04% to 2.12%. The gap between 12-month core CPI and 12-month trimmed mean CPI remains wide, but it should close by May when the impact from last year’s base effects is exhausted (Chart 9, bottom panel). Chart 9Annual Inflation Annual Inflation Annual Inflation Chart 10Monthly Inflation Monthly Inflation Monthly Inflation But base effects were only part of the story last week. Month-over-month inflation also came in very strong for the headline, core and trimmed mean measures. Headline CPI rose 0.62% in March, core CPI rose 0.34% and the trimmed mean rose 0.24% (Chart 10). To put those numbers in context, if those monthly prints are repeated in April and May, 12-month headline CPI will rise to 4.75% by May and 12-month core CPI will rise to 2.79%. Even if we assume more typical 0.15% inflation rates for April and May, we would still expect 12-month headline CPI to reach 3.77% by May and 12-month core CPI to reach 2.41%. Overall, the message from March’s CPI report is that the economy is showing signs of mounting inflationary pressures beyond simple base effects. We have previously written about the ample evidence of bottlenecks in both the goods and service sectors, and we now appear to be seeing those bottlenecks show up in the price data.4 There’s little doubt that 12-month inflation will fall somewhat between May and the end of the year. However, we anticipate that inflation will still be close to the Fed’s target by the end of 2021. This will certainly be the case if the monthly inflation figures remain consistent with March’s print. The main investment implication from this view is that low inflation will not prevent the Fed from tapering its asset purchases either late this year or early next year, and it also won’t prevent the Fed from lifting rates in 2022. Footnotes 1 Greenspan’s remarks: https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021, available at usbs.bcaresearch.com 3 For more details on the Bond Map please see page 16 of US Bond Strategy Portfolio Allocation Summary, “It’s A Boom!”, dated April 6, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Structural headwinds are still too strong to hold a long-term bullish view on Eurozone equities relative to the US. However, the coming two years should be kind to euro area stocks. The relative performance of European stocks compared to that of the US is predominantly a function of yields. BCA foresees higher yields over a 24-month period. Moreover, European equities are exceptionally cheap, which accentuates their appeal as a yield play. Tactical considerations indicate that a modest overweight in European stocks, not an aggressive one, is most appropriate for cyclical investors. European investment grade bonds are appealing in a European fixed-income portfolio. Feature Chart 1Europe's Underperformance Explained Europe's Underperformance Explained Europe's Underperformance Explained Over the past decade, Eurozone equities have massively underperformed US ones. The poor outcome generated by European bourses mimicked the fall in European profits against the US (Chart 1). Considering that the relative performance of euro area stocks stands at an all-time low, should investors begin to bet on Europe? The outlook for yields favors European stocks on a cyclical basis. However, the structural picture suggests that both Europe and the US must experience fundamental changes before European stocks can surpass their US counterparts on a long-term basis.  Structural Challenges Remain The case for overweighting European equities on a structural investment horizon (5 to 10 years) remains weak. Only some major changes in the European and US economies can alter the long-term headwinds facing Eurozone stocks. Table 1US Possesses The Favored Sectors Time And Attraction Time And Attraction Sectoral biases partly explain Europe’s inability to match the US’s profit potential. The US market over-represents high-margin and high return-on-equity businesses, such as technology and healthcare, while most Eurozone bourses have significant weightings in the structurally challenged financial, materials, and energy sectors (Table 1). This difference in sector representation also explains the larger buybacks witnessed in US markets compared to euro area ones, which further boosted the US’s relative EPS. Chart 2Japan Never Recovered Japan Never Recovered Japan Never Recovered The performance of Japanese equities over the past three decades provides another cautionary tale for European stocks. Despite a substantial underperformance in the 1990s, Japanese equities never meaningfully recovered in the 2000s and ended up falling further behind the US over the past 12 years (Chart 2). A powerful liquidity trap and a 23% decline in the Japanese population compared to that of the US seriously hampered the ability of Japanese firms to generate stronger relative cash flows. This challenging profit picture meant that no matter how low JGB rates fell in comparison to the US, Japanese multiples never benefited from a significant re-rerating.  The Eurozone suffers from similar ills to that of Japan, which warns that the latter constitutes a valid template for European assets. Europe’s population is expected to decline by 16% relative to that of the US over the coming three decades, which will hurt sales and capex in Europe. Moreover, despite low interest rates, private credit demand is weak, which limits the region’s economic vigor. Most concerning, Europe’s capital stock as a share of GDP is substantial, especially in the periphery (Chart 3). Such an observation indicates that there is a high probability that previously misallocated capital is burdening the euro area. This misallocation will continue to hurt economic activity, because it encumbers demand via weak capex and also harms productivity. A DuPont decomposition of RoE reveals how Europe’s economic malaise affects corporate profitability (Chart 4). The Eurozone’s excessively large capital stocks means that its asset turnover is inferior to that of the US, which corroborates the notion that capital is misallocated. Moreover, the euro area’s low profit margins reflect more than its sectoral composition. Greater economic rigidities as well as lower market power and concentration in Europe hurt profitability (even if it limits inequalities compared to the US). Finally, the corporate sector is deleveraging, which is a consequence of a liquidity trap and poor trend growth, causing the ratio of RoE to RoA to decline relative to the US. Chart 3Too Much Capital Too Much Capital Too Much Capital Chart 4DuPont De No Good DuPont De No Good DuPont De No Good To reverse the structural outperformance of US equities relative to the Eurozone, Europe’s secular profitability underperformance must end. We will look for the following factors to stop this decline, which we will explore in further detail over time: European reforms. Europe will remain disadvantaged until its excess capital stock is written off. This process is complex and it will require greater fiscal integration as well as greater reforms to promote competition and to decrease labor market as well as service sector rigidities. More Innovation. Despite a strong patent record in economies such as Germany, Europe lags behind the US in the creation of leading innovative companies. Europe’s industrial and consumer discretionary sectors could prove beneficiaries of the green revolution taking place around the world, but it is still too early to tell. Chart 5Market Power Helps The US Market Power Helps The US Market Power Helps The US An ossification of the US economy. Europe could also begin to outperform, because the US might lose its edge. Economic populism is rife in the US, fueled by growing discontent with economic inequalities. As a result, government involvement in the economy as well as regulatory efforts could increase significantly. While a push to redistribute income toward the middle class would alleviate inequalities, it would hurt profitability and cause US RoE to decline toward European levels (Chart 5). Bottom Line: The secular underperformance of Eurozone equities reflects their inability to generate as much profits as US ones. Beyond sector biases, Europe’s demographic hurdles and its deeper problem with secular stagnation remain its key handicaps. For now, there is no solid case to bet on a major change in these trends, which only European reforms or problems in the US can undo. But A Cyclical Opportunity Exists Despite the challenging structural environment for European equities, the cyclical outlook (24 months) is attractive. Even in Japan, multi-year episodes of outperformance punctuated a decades-long underperformance relative to the US or the MSCI all-country world index. In the case of the Eurozone, this upbeat view rests on BCA Research expectations of higher global yields. The performance of Europe’s equities relative to the US correlates closely with the level of US yields (Chart 6). The sectoral footprint of both bourses is an important driver of this correlation. The US overweighs growth and defensive stocks, which account for 49% and 23% of its capitalization, respectively. Meanwhile, the euro area over-represents value stocks and deep cyclicals, which account for 55% and 26% of its market, respectively. Historically, global value stocks beat growth equities when yields are rising (Chart 7).  Chart 6A Yield Story A Yield Story A Yield Story Chart 7What Value Likes What Value Likes What Value Likes The outperformance of value stocks when yields rise is multifaceted. Deep cyclicals, such as industrials, materials, financials and energy, constitute a larger share of value benchmark than growth ones. Consequently, when yields increase because the global business cycle experiences an upswing, the earnings of value stocks accelerate compared to those of growth stocks (Chart 7, bottom panel). The positive impact of yields on the value versus growth split is also more direct. Higher yields, especially if they accompany a steeper yield curve, boost the profitability of financials. Meanwhile, mounting yields increase the discount factor applied to the long-term deferred cash flows that contribute a large proportion of the intrinsic value of growth stocks. Higher yields also support the relative performance of Eurozone stocks via the evolution of the expected growth rates of their long-term earnings. As Chart 8 illustrates, upgrades to sell-side estimates of the long-term growth rate of European EPS relative to the US coincide with a steeper US yield curve slope and rising 5-year/5-year forward Treasury yields. These relationships exist because European economic activity and sectoral representation are more cyclical than that of the US.  Eurozone equities look like a particularly cheap bet on higher yields over the coming 18 to 24 months. Sentiment toward European assets remains depressed compared to the US. Even on an equal-weighted basis, the discount of the expected long-term growth rate of euro area EPS relative to the US is exceptionally wide (Chart 9, top panel). True, the sustainable growth rate (SGR) of earnings is a function of the return on equity and the dividend payout ratio. Nonetheless, despite the fact that the euro area low RoE forces the European SGR down, Eurozone stocks embed a long-term growth rate that is 47% too low vis-à-vis the US. Other metrics underscore the cheapness of European equities relative to the US. Our Mechanical Valuation Indicator, which is sector neutral, stands at a 1-sigma discount in favor of the Eurozone (Chart 9, bottom panel). Chart 8EPS Growth and The Yield Structure EPS Growth and The Yield Structure EPS Growth and The Yield Structure Chart 9Europe Is Cheap Europe Is Cheap Europe Is Cheap Ultimately, Europe’s relative expected growth and valuations are particularly depressed, because domestic activity lags behind that of the US by a significant margin. As the vaccination campaign advances and the economy reopens later in the quarter, the Eurozone’s service sector will catch up and the earnings growth discount will dissipate (Chart 10). Moreover, regardless of its recent dynamism, even the European industrial sector has room to catch up to the US. Our Swedish Economic Diffusion Index captures the general strength in Swedish economic activity, which foretells a further increase in both the euro area Manufacturing PMI and equities relative to the US (Chart 11). Chart 10Stronger Services Will Help Stronger Services Will Help Stronger Services Will Help Chart 11Listen To Sweden Listen To Sweden Listen To Sweden Bottom Line: BCA’s expectations that global yields will rise over the coming 24 months are consistent with Eurozone equities outperforming US ones over this period, even if the long-term outlook remains challenging for Europe. European equities are much more pro-cyclical than US ones, which is reified by their sector and value biases. Moreover, euro area equities currently embed a particularly large discount to their US counterpart, which increases their attractiveness as a play on rising bond yields. The Right Entry Point? Strategy and forecasts are two different things. BCA strongly believes that yields will rise over the coming two years; however, a large overweight in Eurozone equities is a risky bet at the current juncture. Instead, we recommend investors opt for a modest overweight. Short-term traders should stay clear of this market for now. The reason for this cautiousness is that yields are very vulnerable to a temporary near-term pullback because: Chart 12A Countertrend Bond Rally? A Countertrend Bond Rally? A Countertrend Bond Rally? Technicals point to a counter-trend bounce in bond prices. Our BCA Composite Technical Indicator is massively oversold, our Composite Sentiment Indicator is extremely depressed, and speculators are aggressively shorting T-Bonds (Chart 12). The recent bond market behavior is puzzling. Despite March’s blockbuster non-farm payroll data and Manufacturing, as well as Services ISM surveys, yields are softening. Not even the announcement of the Biden administration’s $2.3 trillion American Jobs Plan could increase yields in recent weeks. This price action confirms that bonds are oversold and that, until the recent price decline is digested, the threshold to push yields higher has risen meaningfully. Equities are at risk of a pullback. Euphoria is prevalent, which increases the odds of corrective action in equities. Our BCA Equity Capitulation Index stands at a 45-year high (Chart 13) and our US Equity Strategy team’s Risk Appetite Index is at its highest levels since 2007, both of which suggest that complacency is rife. Moreover, the put/call ratio has collapsed to 0.45, which shows the carefree attitude of traders. Yields will decline if stock prices correct. EM equities are underperforming US stocks. EM benchmarks are more sensitive to marginal changes in the global growth outlook. For now, the risk is that growth disappoints lofty expectations. Since 2014, periods of relative weakness in EM bourses precede declines in Treasury yields (Chart 14). Authorities are trying to limit credit growth in China. As we argued two weeks ago, Beijing is aiming to slow credit growth to prevent systemic vulnerabilities from developing. This process is fraught with risks and is likely to result in a deceleration in China’s economy. While Europe and most emerging markets remained mired in a health crisis, China will be a source of temporary downside for global economic activity. The recent announcement that the PBoC asked Chinese banks to limit new loans confirms this assessment. Chart 13Euphoria! Euphoria! Euphoria! Chart 14EM Stocks Are Telling Us Something EM Stocks Are Telling Us Something EM Stocks Are Telling Us Something Bottom Line: For now, investors with a cyclical horizon (two years) should only keep a modest overweight position in Eurozone equities because the near-term outlook for yields points to some temporary downside. Not allocating the full allowable capital budget to Europe will allow investors to upgrade their overweight after the near-term downside in yields has passed. Investors may also consider implementing some hedges. Our foreign exchange strategist recommends a short EUR/JPY position as a form of portfolio protection. Keeping some cash in yen to deploy later in Europe mimics this advice. Short-term traders should stay clear of Europe as long as bond markets have not digested their oversold condition. Market Focus: Investment Grade Corporates and the ECB The ECB’s minutes highlight that investment grade corporate bonds are attractive within European fixed-income portfolios. The recently released ECB minutes revealed that higher real rates do not overly concern the Governing Council, because they reflect an improving global economic outlook and not an eventual policy tightening. Moreover, the GC does not want to give the impression it will engage in yield control, yet the pace of purchases under the Pandemic Emergency Purchase Programme (PEPP) will remain accelerated and flexible until June, at a minimum. The ECB will not derail the supportive environment for economic activity anytime soon. Meanwhile, as we have argued in past reports, fiscal policy in Europe will also stay relaxed for the time being. Thus, the Eurozone’s policy environment remains supportive for credit spreads, especially since the default cycle has been muted. However, do corporate bonds already fully price in this positive backdrop? According to the 12-month breakeven spread, European credit spreads can compress further. The breakeven spread is the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It is approximated by dividing the OAS of a bond (or an index) by its duration. The breakeven spread is then compared to its own history, by observing the percentage of time that it has been lower in the past.1  Chart 15Some Value Left Some Value Left Some Value Left European credit spreads have tightened 160 bps since March last year and are already below their pre-Covid level (Chart 15). However, the 12-month breakeven spread has been tighter 18% of the time since 1999. In other words, higher quality corporate bonds in Europe have room to see further spread compression, since policy will remain relaxed for a long time. This is especially true in the Aa-rated credit tier, where the breakeven spread has been more expensive 35% of the time (not shown). Meanwhile, US breakeven spreads for IG corporate bonds are in their 2nd percentile and policy will tighten sooner than in Europe. Therefore, bond investors with a European-only mandate are not forced to step down the quality ladder as aggressively as those in the US do. Table 2Norway, France And Italy Stand Out Time And Attraction Time And Attraction Table 2 provides the same analysis at the country level. Taking into consideration the average credit rating of each countries’ investment grade bonds, we find that Norwegian, French, and Italian spreads have the most value left. Interestingly, the ECB’s purchases of Italian and French paper is currently deviating widely from its capital keys, which should place downward pressure on credit spreads in these jurisdictions. Bottom Line: There is still value left in European investment grade corporate bonds, unlike in the US, where valuations are extremely expensive and a decrease in quality is warranted. For now, such a move is uncalled for in Europe, especially since the value in its high-yield index is concentrated in its riskiest credit tiers. At the country level, investors should favor Norwegian, French, and Italian investment grade corporate bonds.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Jeremie Peloso, Senior Analyst JeremieP@bcaresearch.com   Footnotes 1We find this valuation tool superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.   Cyclical Recommendations Structural Recommendations Trades Currency Performance Time And Attraction Time And Attraction Fixed Income Performance Government Bonds Time And Attraction Time And Attraction Corporate Bonds Time And Attraction Time And Attraction Equity Performance Major Stock Indices Time And Attraction Time And Attraction Geographic Performance Time And Attraction Time And Attraction Sector Performance Time And Attraction Time And Attraction Closed Trades

Highlights Q1/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +55bps during the first quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +68bps, led overwhelmingly by our underweight to US Treasuries (+63bps). Spread product allocations underperformed by -11bps, primarily due to an overweight on UK corporates (-8bps). Portfolio Positioning For The Next Six Months: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral. Feature The first quarter of 2021 saw a sharp sell-off in global bond markets on the back of rising growth expectations, fueled by US fiscal stimulus and vaccine optimism. The US was near the front of the pack, with 10-year Treasuries having their biggest first quarter sell-off since 1994. Accommodative financial conditions, fueled by a highly stimulative mix of monetary and fiscal policies and improving sentiment, have lit a fire under a global economy set to reopen from pandemic lockdowns. Going forward, we expect US growth to continue leading the way, with implications for the dollar, commodity prices, and the expected path of policy rates. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the first quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2021 Model Portfolio Performance Breakdown: Steering Clear Of Duration Chart 1Q1/2021 Performance: Bearish UST Bets Pay Off Q1/2021 Performance: Bearish UST Bets Pay Off Q1/2021 Performance: Bearish UST Bets Pay Off The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -1.83%, dramatically outperforming the custom benchmark index by +55bps (Chart 1).1 This follows modest outperformance in 2020 which was driven largely by overweights on spread product initiated after the pandemic shock to markets. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +68bps of outperformance versus our custom benchmark index while the latter underperformed by -11bps. Our allocations to inflation-linked bonds in the US, Canada and Europe - which were a source of outperformance in 2020 - modestly underperformed this quarter (-2bps) as global real yields finally began to pick up. Our outperformance this quarter was driven overwhelmingly by our decision to go significantly underweight US Treasuries, and to position for a bearish steepening of the Treasury curve, ahead of last November’s US presidential election (Table 2). That resulted in the US Treasury allocation generating a massive +63bps of excess return in Q1/2022 as longer-term US yields surged higher. Table 2GFIS Model Bond Portfolio Q1/2021 Overall Return Attribution GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening The size of the US underweight was unusually large as we maintained only a neutral exposure to the other “high beta” markets that are typically positively correlated to US yield moves, Canada and Australia. Although the returns for those two government bond markets were very similar to that of US Treasuries in Q1, so the choice to stay neutral even with a bearish directional view on US yields did not impact the overall portfolio performance. Overweights to the more defensive “low beta” markets of Germany, France and Japan contributed a combined +4bps. We did see some losses on nominal government bonds in peripheral Europe (Italy: -0.6bps; Spain: -1.9bps), however, with the narrowing in spreads thrown off by a botched vaccine rollout. In spread product, underperformance came from overweights to UK investment grade corporates (-8bps), US CMBS (-4bps), and EM USD-denominated corporates (-2bps). This was despite the fact that spreads for UK corporates remained flat while US CMBS spreads actually narrowed. These losses were slightly offset by the overweight to lower-rated US high-yield (+3bps) and underweight to US agency MBS (+2bps). Our spread product losses, in total return terms, highlight the importance of considering duration risk when making a call on spread product, especially at a time when sovereign yields are rising and spreads offer little “cushion”. Duration also played a big part in nominal government bond outperformance, with a whopping +43bps of our total +55bps outperformance concentrated in just US Treasuries with a maturity greater than 10 years. In other words, overweighting overall global spread product and underweighting government bonds still generated major portfolio outperformance, even if there was a more mixed bag of returns within that credit overweight. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Chart 3GFIS Model Bond Portfolio Q1/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+43bps), maturity between 7 and 10 years (+11bps), and with a maturity between 5 and 7 years (+7bps) Overweight US high-yield (+3bps) Underweight US agency MBS (+2bps) Overweight Italian inflation-indexed BTPs (+2bps) Biggest Underperformers: Overweight UK investment grade corporates (-8bps) Overweight US agency CMBS (-4bps) Overweight Spanish government bonds (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2021 GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. On that front, our portfolio allocations performed exceptionally well in Q1. In total return terms, the global bond market sell-off was a disaster for both government bonds and spread product. US high-yield, one of our longer-standing overweights, was the only sector to emerge unscathed, delivering a positive return of +42bps. Within our government bond allocation, the “defensive” markets—Japan (-44bps), Germany, (-261bps) and France (-371bps)—were nevertheless shaken by rising yields. On the other hand, we limited our downside by maintaining a neutral stance on the higher beta markets such as Canada (-406bps), New Zealand (-415bps), and the UK (-1389bps). Gilts sold off especially sharply as the UK outperformed global peers on COVID-19 vaccinations while inflation expectations continued to pick up. Our two underweights, US Treasuries (-426bps) and European high-yield (-426bps), were prescient. The latter market was one we chose to underweight given that spreads didn’t offer nearly enough compensation on a default-adjusted and breakeven basis. Bottom Line: Our model bond portfolio outperformed its benchmark index in the first quarter of the year by +55bps – a positive result driven by our underweight allocation to the US Treasury market and overall below-benchmark global duration stance. Future Drivers Of Portfolio Returns & Scenario Analysis Chart 5More Growth-Driven Upside For Global Yields Ahead More Growth-Driven Upside For Global Yields Ahead More Growth-Driven Upside For Global Yields Ahead Looking ahead, the performance of the model bond portfolio will continue to be driven predominantly by the future moves of global government bond yields, most notably US Treasuries. Our most favored leading indicators for global bond yields continue to signal more upside over at least the next six months (Chart 5). Our Global Duration Indicator, comprised of measures of future economic sentiment and momentum, remains at an elevated level. The ongoing climb in the global manufacturing PMI, which typically leads global real bond yields by around six months, suggests that the recent uptick in real yields can continue into the second half of 2021. We are still maintaining a bias towards bearish yield curve steepening across all the countries in the model bond portfolio. It is still far too soon to see bearish flattening of yield curves given the dovish bias of global central banks, many of which are actively targeting an overshoot of their own inflation targets. The US will be the first central bank to see any bearish flattening pressure, as the market more aggressively pulls forward the liftoff date of the next Fed tightening cycle in response to strong US growth, but that is an outcome we do not expect until well into the second half of 2021. With regards to country allocations within the government bond segment of the model bond portfolio, we continue to focus our maximum underweight on the US, while limiting exposure to the markets that are more sensitive to changes in US interest rates (Chart 6). Those “lower yield beta” markets (Germany, France and Japan) will continue to outperform the higher beta markets (Canada, Australia) over the latter half of 2021. We currently have Canada on “downgrade watch”, as economic momentum is accelerating and the housing bubble looks to be reflating, both of which will make the Bank of Canada turn more hawkish shortly after the Fed does. We are more comfortable keeping Australia at neutral, as Australian inflation is likely to remain too underwhelming for the Reserve Bank of Australia to turn less dovish and risk a surge in the Australian dollar. UK Gilts are a more difficult case, atypically acting like a lower beta market over the past few years. As we discussed in a Special Report published last month, we attribute the declining Gilt yield beta to the rolling shocks the UK has suffered over the past thirteen years – the 2008 global financial crisis, the 2012 euro area debt crisis, Brexit and, now, COVID-19 – that have hamstrung the Bank of England’s ability to try even modest interest rate hikes.2 With the impact of those shocks on UK growth now diminishing, we see the central bank under greater pressure to begin normalizing UK monetary policy over the couple of years. We downgraded our cyclical stance on UK Gilts and UK investment grade corporates to neutral from overweight in that Special Report and, this week, we are making the same reduction in UK weightings in our model bond portfolio (see the portfolio tables on pages 20-21). After that change, the overall duration of the model bond portfolio remains below that of the custom benchmark index, now by -0.75 years (Chart 7). Chart 6Low-Beta Markets Will Continue To Outperform USTs Low-Beta Markets Will Continue To Outperform USTs Low-Beta Markets Will Continue To Outperform USTs Chart 7Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark We continue to see the dovish bias of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt (Chart 8). Yes, the “easy money” has been made betting on a recovery of inflation expectations from the bombed-out levels seen after the COVID-19 recession in 2020. However, within the major developed economies with inflation-linked bond markets, 10-year breakevens have already climbed beyond the pre-pandemic levels of early 2020 (Chart 9). The next targets are the previous cyclical highs seen in 2018 (and 2019 for the UK). Chart 8Dovish Central Banks Still Positive For Inflation-Linked Bonds Dovish Central Banks Still Positive For Inflation-Linked Bonds Dovish Central Banks Still Positive For Inflation-Linked Bonds Chart 9Inflation Breakevens Returning To Past Cyclical Peaks Inflation Breakevens Returning To Past Cyclical Peaks Inflation Breakevens Returning To Past Cyclical Peaks Chart 10Still A Supportive Backdrop For Global Corporates Still A Supportive Backdrop For Global Corporates Still A Supportive Backdrop For Global Corporates The 10-year US TIPS breakeven is already past that 2018 peak of 2.18%, and with the Fed showing no sign of concern about US growth and inflation accelerating, the 10-year US breakeven should end up moving into the high end of our expected 2.3-2.5% target range before the Fed begins to turn less dovish. Thus, we are maintaining a core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy, France and Canada. The same aggressive easing of global monetary policy that has been good for relative inflation-linked bond performance continues to benefit global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England remains an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). With the combined balance sheet now expanding at a 55% pace, corporate bonds are still likely to continue to outperform government debt over the remainder of 2021. Much of that expected return outperformance of corporates will come via carry rather than spread compression, though. Our preferred measure of the attractiveness of credit spreads, the historical percentile ranking of 12-month breakeven spreads, shows that only US high-yield spreads are above the bottom quartile of their history among the credit sectors in our model portfolio (Chart 11). Given the absence of spread cushion in those other markets, we are maintaining an overweight stance on US high-yield in the model bond portfolio – especially versus euro area high-yield where we are underweight - while staying neutral investment grade credit in the US and Europe. Chart 11US High-Yield: The Last Bastion Of Attractive Spreads GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Within the euro area, we continue to prefer owning Italian government bonds over investment grade corporates, given the European Central Bank’s more explicit support for the former through quantitative easing (Chart 12). We expect Italian yields and spreads to converge down to Spanish levels, likely within the next 6-12 months, while there is limited downside for euro area investment grade spreads given tight valuations. Chart 12Favor Italian BTPs Over Euro Area IG Favor Italian BTPs Over Euro Area IG Favor Italian BTPs Over Euro Area IG We are not only looking at relative valuation considerations in developed market credit. Emerging market (EM) USD-denominated credit has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices. We have positioned for that in our model portfolio through an overall overweight stance on EM USD credit, but one that favors investment grade corporates over sovereigns. Now, with the Chinese credit impulse likely to slow in the latter half of 2021 as Chinese policymakers look to rein in stimulus, a slower pace of Chinese economic growth represents a risk to EM credit (Chart 13). The same can be said for the US dollar, which is no longer depreciating with US bond yields rising and the markets questioning the Fed’s dovish forward guidance on future rate hikes (Chart 14). A strong US dollar would also be a risk to the commodity price rally that has supported EM financial assets. Chart 13Global Policy Mix Becoming Less Supportive For EM Global Policy Mix Becoming Less Supportive For EM Global Policy Mix Becoming Less Supportive For EM Chart 14A Stronger USD Is A Risk For EM Corporates Vs Sovereigns A Stronger USD Is A Risk For EM Corporates Vs Sovereigns A Stronger USD Is A Risk For EM Corporates Vs Sovereigns Chart 15A Moderate Overweight To Spread Product Vs Government Debt GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening In response to these growing risks to the bullish EM backdrop, we are downgrading our overall EM USD credit exposure in the model bond portfolio to neutral from overweight. We are maintaining our relative preference for EM investment grade corporates over sovereigns, however, within that overall neutral allocation. Summing it all up, we are sticking with a moderately overweight stance on global spread product versus government debt in the model portfolio, equal to four percentage points (Chart 15). That overweight comes entirely from the US high-yield allocation. After the changes made to our UK and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 41bps (Chart 16). This is an unsurprising outcome given that the current positioning is focused so heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral. That will change as 2021 progresses but, for now, our highest conviction views are in US fixed income. One final point – the relatively concentrated positioning leaves the portfolio “flat carry”, with a yield roughly equal to that of the benchmark index (Chart 17). Chart 16Limited Use Of Portfolio 'Tracking Error' Limited Use Of Portfolio 'Tracking Error' Limited Use Of Portfolio 'Tracking Error' Chart 17Model Portfolio Yield Close To Benchmark Model Portfolio Yield Close To Benchmark Model Portfolio Yield Close To Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the UK and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Base case: Ongoing global vaccinations lead to more of the global economy reopening over the summer, with excess savings built up during the pandemic – augmented by ongoing fiscal support – starting to be spent. US economic growth will be most robust out of the major economies, given the additional boost from fiscal stimulus, while China implements actions to slow credit growth and the euro area lags on vaccinations. The Fed stands its ground and maintains no rate hikes until at least 2023, and US TIPS breakevens climb to levels consistent with the Fed’s 2% inflation mandate (2.3-2.5%). The US Treasury curve continues to bear-steepen, with the 10-year US yield rising to 2%. The VIX falls to 15, the US dollar is flat, the Brent oil price rises +5%, and the fed funds rate is unchanged at 0%. Optimistic case: A rapid pace of global vaccinations leads to booming growth led by the US but including a reopening euro area. Chinese policymakers tighten credit by less than expected. Markets begin to pull forward the timing and pace of future central bank interest rate hikes, most notably in the US but also in the other countries like Canada and the UK. Real bond yields continue to climb globally, but inflation breakevens stay elevated. The steepening trend of the US Treasury curve ends, and mild bear flattening begins with the 10-year reaching 2.2% and the 2-year yield climbing to 0.4%. The VIX stays unchanged at 18, the US dollar rises +5%, the Brent oil price climbs +2.5% and the fed funds rate stays unchanged. Pessimistic case: Setbacks on the pandemic, either from struggles with vaccine distribution or a surge in variant cases, lead to a slower pace of global growth momentum. Europe cannot reopen, China tightens credit policy faster than expected, and US households hold onto to excess savings amid lingering virus uncertainty. Diminished economic optimism leads to a pullback in global equity values and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.5%. The VIX rises to 25, the US dollar falls -2.5% and the fed funds rate stays at 0%. The inputs into the scenario analysis are shown in Chart 18 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 19. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening The model bond portfolio is expected to deliver an excess return over the next six months of +46bps in the base case and +54bps in the optimistic scenario, but is only projected to underperform by -27bps in the pessimistic scenario. Bottom Line: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1How Long Until Full Employment? How Long Until Full Employment? How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification It’s A Boom! It’s A Boom! Table 2Fixed Income Sector Performance It’s A Boom! It’s A Boom! Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s A Boom! It’s A Boom! Table 3BCorporate Sector Risk Vs. Reward* It’s A Boom! It’s A Boom! High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) It’s A Boom! It’s A Boom! Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) It’s A Boom! It’s A Boom! Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) It’s A Boom! It’s A Boom! Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) It’s A Boom! It’s A Boom! Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Rates Are Rising Everywhere Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Global Excess Savings Total $3 Trillion Global Excess Savings Total $3 Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Chart 6Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 ...Since This Is As Early As Q3 2021 ...Since This Is As Early As Q3 2021 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing ...With The Possible Exception Of Housing ...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global Economy Chart 18US Growth Already Looks Strong... US Growth Already Looks Strong... US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening China Is Risking Overtightening China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places Financials And Tech: Trading Places Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Stay Long TIPS Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Limited Upside For Oil From Here Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Turning More Positive On Private Equity Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Is Perfection Priced In? Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? China Slowing Again? China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation