Financial Markets

Executive Summary First IG, Then HY Corporate bonds are following the 2018 roadmap. Investment grade underperformed Treasuries as interest rate expectations rose from low levels, then junk joined the selloff once rate expectations moved above estimates of neutral. Inflation is too high for the Fed to abandon its tightening cycle, as it did in 2018/19, but the Fed will move more slowly than what is priced in the curve for 2022. Underlying economic growth is stronger than it was in 2018 and corporate balance sheets are in better shape. That being the case, even a modest dovish surprise from the Fed will be sufficient for corporate bond returns to form a bottom. Municipal bonds are attractively priced versus both Treasuries and credit, and state & local government balance sheets are in excellent condition. Stay overweight.   Bottom Line: We maintain our cautious stance on corporate bonds for the time being, but are now on upgrade watch. Signs of peaking inflation and/or dovish signals from the Fed could cause us to increase exposure in the relatively near term. Stay tuned.  Feature The similarities between recent market action and what occurred in 2018 are striking. Back in 2018, the Fed was in the process of lifting the policy rate back toward estimates of neutral. The yield curve flattened as a result, and investment grade corporate bonds responded to the removal of policy accommodation by underperforming duration-matched Treasuries (Chart 1). Chart 1The 2018 Experience Despite the Fed’s actions, high-yield initially performed well in 2018. That is, until the market started to believe that the Fed would over-tighten. Recession fears increased in late 2018 as near-term rate expectations surpassed estimates of neutral and high-yield sold off sharply, giving back all of its gains from earlier in the year and then some. Now let’s turn to the present day (Chart 2). Once again, investment grade corporates underperformed Treasuries as near-term rate expectations moved higher and the yield curve flattened. For its part, high-yield performed well during the early stages of the interest rate adjustment but returns plunged once 12-month forward rate expectations moved above survey estimates of neutral. Chart 2First IG, Then HY What’s Different This Time? While we think the 2018 roadmap is a good one, it’s important to consider the differences between 2018 and today before drawing any firm conclusions about future credit market performance. The first obvious difference is that the Fed had already been lifting rates for some time in 2018. In fact, the fed funds rate was above 2%. Today, the Fed is still in the early stages of its tightening cycle and the fed funds rate is only 0.83%. We think this difference is less significant than it initially appears because the level of the fed funds rate itself is less important than the perceived restrictiveness of monetary policy. Today, the market is priced for the fed funds rate to hit 3.18% in 12 months, higher than at any point in 2018 (Chart 3). We also see that the Treasury slope beyond the 2-year maturity point is about as flat today as it was in 2018 (Chart 3, bottom panel). This strongly suggests that the market perceives monetary policy as about as restrictive today as it was in late 2018. The second difference we identify is that inflation is much higher today than it was in 2018 (Chart 4). This is potentially bad news for future credit market performance. High inflation gives the Fed a strong incentive to keep lifting rates even if risky assets sell off. In 2018, the Fed reversed course on its tightening cycle once broad financial conditions tightened into restrictive territory. That’s an easy decision to make when inflation is close to 2%. It’s much more difficult to do with inflation where it is now. Chart 3Monetary Conditions Are Similar Chart 4Inflation Is Much Higher … High inflation makes it unlikely that the Fed will pull a 180 on its tightening cycle. But on the flipside, today’s strong underlying economic growth means that a complete reversal on rate hikes is probably not necessary to avoid a recession. Just look at the labor market. Labor market utilization, as measured by both the unemployment rate and the prime-age employment-to-population ratio, is in a similar place today as it was in 2018 (Chart 5). However, despite a tight labor market, job growth is running at a much stronger pace this year. Nonfarm payroll gains have averaged 523 thousand during the past three months. In 2018, in a similarly tight labor market, monthly job growth averaged just 191 thousand. Now turn to housing, arguably the most important channel through which interest rates impact the economy. In a prior report we identified that the 12-month moving average of housing starts dipping below the 24-month moving average is a good indicator for the end of a Fed rate hike cycle.1 In 2018, our housing starts indicator was barely positive. Today, it is extremely elevated (Chart 5, bottom panel). Chart 5… But Growth Is Much Stronger The key point is that with employment growth and housing starts trending at much better levels than in 2018, we can conclude that the Fed has a fair amount of scope to tighten policy before threatening to push the economy into recession. The upshot for corporate bond markets is that the threshold for Fed capitulation is also different. While a full backtracking away from rate hikes was necessary to avoid a recession and spur corporate bond outperformance in 2018, both the economy and financial markets likely require less of a Fed reversal today. The final difference we identify between 2018 and today relates to the health of corporate balance sheets (Chart 6). Compared to 2018, nonfinancial corporations are carrying much less debt as a percentage of net worth, have significantly higher interest coverage and are benefiting from net ratings upgrades. Much like with the labor market and housing indicators, there’s every reason to believe that corporations are better equipped to handle higher interest rates today than they were in 2018. Chart 6Balance Sheets Are Healthier The Way Forward If we look back at Chart 1, we see that the 2018 roadmap is for the Fed to abandon its tightening cycle, leading to a sharp drop in near-term rate expectations and a V-shaped bottom in excess corporate bond returns. We won’t get such a swift Fed reversal this year, but there are strong odds that the Fed will lift rates by less than what is currently discounted in the market between now and the end of 2022. As we noted in last week’s Webcast, we expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before shifting to 25 bps per meeting increments in September once it’s clear that inflation is trending down (Chart 7).2  We also see potential for relief at the long-end of the yield curve, where 5-year/5-year forward Treasury yields have room to fall back toward survey estimates of the long-run neutral rate (Chart 8). Chart 7Rate Expectations Chart 8Yields Above Fair Value It’s also worth noting that corporate bond valuations have improved markedly during the past few weeks. The 12-month breakeven spread for investment grade corporates is back above its historical median, and the junk index is priced for a 6.3% default rate during the next 12 months (Chart 9). Investment grade and high-yield index spreads are also now well above their respective 2017-19 averages, as is the spread differential between high-yield and investment grade (Chart 10). Chart 9Corporate Bond Valuation Chart 10Favor HY Over IG The bottom line is that we are slowly turning more positive on corporate bonds. Falling inflation will cause the Fed to tighten by less than what is expected this year, and it will soon become apparent that – as was the case in 2018 – the US economy is not close to tipping into recession. Spreads also present an increasingly attractive opportunity. That said, with the Fed still poised to deliver 100 bps of tightening within the next two months, we are not yet ready to abandon our relatively cautious corporate bond allocation. We maintain our underweight (2 out of 5) allocation to investment grade corporate bonds and our neutral (3 out of 5) allocation to high-yield, but we are now firmly on upgrade watch. Signs of peaking inflation and/or signals that the Fed will pivot to a hiking pace of 25 bps per meeting could cause us to increase our recommended corporate bond exposure in the relatively near term. Stay tuned. Seek Refuge In Municipal Bonds While we wait for clearer signs of a bottom in corporate credit, investors can more confidently deploy capital in the municipal bond market. Municipal / Treasury yield ratios have jumped in recent weeks, and they are now back above post-2010 averages across the entire yield curve (Chart 11). Long-maturity municipal bonds are even trading at a before-tax premium relative to US Treasuries (Chart 11, top 2 panels). Municipal bonds are also trading at above-average yields relative to credit rating and duration-matched corporate bonds (Chart 12). This is despite the recent back-up we’ve witnessed in corporate bond spreads. Chart 11Muni / Treasury Yield Ratios Chart 12Munis Cheap Versus Credit Not only are munis attractively priced versus both Treasuries and corporates, but state & local government balance sheet indicators show that municipal credit quality is sky high (Chart 13). Tax revenues have accelerated since the pandemic, but state & local governments have remained cautious about spending their windfalls. Despite being flush with cash, state & local governments have re-hired only a small fraction of the employees that were let go during the pandemic (Chart 13, panel 2). The result of this lack of spending is that state & local government net savings are the highest they’ve been in years (Chart 13, panel 3). Chart 13State & Local Government Health Bottom Line: Municipal bonds are attractively valued versus both Treasuries and investment grade corporates, and state & local government balance sheets are in superb condition. Investors should overweight municipal bonds in US fixed income portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 2 https://www.bcaresearch.com/webcasts/detail/537 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary The sharp slide in the S&P 500 forward multiple has been painful, but it's only two-thirds of the way to its 1987 and 2002 declines. The inverse correlation between interest rates and the index P/E multiple is well established; if rates stop backing up, the multiple will stop being squeezed. Stocks would really be in trouble if their gains had entirely been a function of multiple inflation, but earnings growth has done the heavy lifting since 2008. Earnings growth will likely decelerate over the rest of the year, but it will remain a tailwind. A model regressing the index's forward multiple against a proprietary measure of inflation expectations and consumer perceptions of the labor market does a good job of explaining past valuation moves. If inflation has peaked and labor demand remains strong, multiples may be able to retrace some of their losses. De-Rating May Have Gone A Little Too Far Bottom Line: Although the 23% de-rating in equity valuations has been severe, it is not unprecedented – larger declines occurred in 1987 and 2002. While we estimate that the forward multiple’s fair value is one or two points above its current level, there is no timetable for when the actual multiple will return to it. Feature Our client conversations over the last few weeks have ultimately found their way to the issue that is front of mind for nearly all investors: Is the equity selloff almost finished, and how far will it go if it’s not? When analyzing equity performance, we find it useful to decompose the S&P 500 into expected earnings and the multiple investors are willing to pay for them. Solid full-year US growth remains our base-case scenario, even if our conviction has declined as inflation has bounded higher, Russia’s invasion of Ukraine has turbo-charged geopolitical tensions while crimping commodity supplies, and China’s response to its COVID surge threatens to undo tentative supply-chain progress. We therefore view moves in the S&P 500’s forward P/E multiple as the key swing factor. This report gathers our responses to several client questions that touch on multiples and presents some new research related to them. Our goal is to bring some fresh insights to the discussion while encouraging more clients to engage with it. Previous De-Rating Episodes Multiples have lost a lot of ground in a short period of time. Is there any precedent for what we’ve seen so far this year? Reliable consensus earnings estimates have only been compiled since 1979, so the entire history of forward multiple data is confined to the last 40-plus years. Over that timeframe, there have been two other periods when the month-end index multiple fell at least as much over a similarly brief stretch (Chart 1, top panel). The first occurred in 1987, when the forward multiple fell five points from 14.8 at the end of August to 9.8 at the end of November, a stunning three-month 33% valuation haircut that largely unfolded during Black Monday’s single-session bear market. The second occurred as the bear market that followed the dotcom bust careened to its conclusion, with the forward multiple again falling by a third, from 21.6 at year-end 2001 to 14.5 at the end of September 2002. Chart 1Multiples Can Reverse Suddenly The year-to-date decline of just under five multiple points, from 21.6 at year-end to 16.7 as of Wednesday’s close, has amounted to a 23% valuation adjustment in four-and-a-half months that has driven the index 18% lower. In standardized terms, the index multiple has matched 1987 with a 1.15-standard-deviation tumble, but it is still a half of a standard deviation shy of 2002’s swoon (Chart 1, bottom panel). The multiple’s 1.5-standard-deviation slide from its August 2020 month-end peak is a full standard deviation less than the 2.5-standard-deviation peak-to-trough flogging it endured during the dotcom bust. Bottom Line: The current selloff has been severe, but it is not unprecedented. Multiples can compress swiftly, especially when they are as elevated as they have been since stocks bottomed amidst the initial shock of the pandemic. Matching 1987's and 2002's 33% haircuts would involve lopping off another two multiple points and knocking the index down to the low 3,400s. Multiples And Interest Rates The history is scary. 3,400 would take us right back to where we were before the vaccines arrived and wipe out a year and a half of gains, but I take some comfort from still-low interest rates. Stocks may not be cheap relative to the whole 43-year history, but am I wrong to think they look pretty appealing given a 3% 10-year Treasury yield? Related Report  US Investment StrategyQ&A About Rate Hikes And Stocks Interest rates provide the means for discounting future cash flows back to their present value and the theoretical link between multiples and interest rates is rock solid. When long-dated Treasury yields fall, the present value of a company’s future earnings rises, all else equal, and when yields rise, present value falls. All is not equal, of course, and earnings are prone to moving with interest rates, but the inverse relationship between interest rates and the present value of a fixed series of future cash flows is as constant as the tides. The empirical history shows that the theory holds up in the real world. The inverse relationship between S&P 500 forward multiples and 10-year Treasury yields is robust, with the level of yields explaining 46% of the variation in S&P 500 valuations since the forward multiple series began (Chart 2, top panel). The simple regression fit is undermined by the circled cluster of outlying observations with yields between 4.5 and 6.75% and forward multiples of 18 and above, all of which occurred between January 1997 and May 2002, when the dotcom mania severed the link between valuations and rates. When those observations are removed, the relationship becomes even stronger, with the level of yields explaining 69% of the variation in S&P 500 valuations (Chart 2, bottom panel). Chart 2When Rates Zig, Multiples Zag Removing the dotcom observations from the datasets highlights the variability of forward valuations within the 0.5-4% range of Treasury yields that has prevailed since 2008. The observations well below the best-fit regression line occurred soon after the onset of the global financial crisis, when a growth shortfall loomed as the biggest threat and deflation was a plausible outcome. The observations well above the best-fit line were recorded since the pandemic, as the economy rode a wave of fiscal and monetary steroids whose potentially inflationary side effects were beyond the marginal price-setters’ decision horizon. We note that multiples are most likely headed back below the best-fit line if stagflation risks are perceived to grow in line with many investors’ fears. The equity risk premium (ERP), calculated as the forward earnings yield (the inverse of the forward multiple) less the real 10-year Treasury yield, offers a rosier perspective for viewing the interaction between interest rates and equity valuations. It supports the notion that equity prices are attractive, given the current yield backdrop, and draws a sharp distinction between the pandemic’s 20-plus multiples and the dotcom era’s (Chart 3). Simple regression against the 10-year Treasury yield suggests that the S&P 500 is now fairly valued, while the ERP argues that it’s somewhat cheap. Equity valuations are vulnerable to further yield backups under both approaches, however. Chart 3Compared To Bonds, Equities Are Cheap Bottom Line: Multiples deserve to be elevated, relative to their history, given that long-dated Treasury yields remain near the bottom of their historical range, but they face more de-rating pressure if yields continue to rise. What Goes Around Comes Around The de-rating that’s occurring right now shouldn’t surprise anyone who’s stopped believing in Santa Claus and the tooth fairy. The Fed has manufactured the entire post-crisis rally with zero interest rates and QE and we’re simply witnessing the inevitable unwind. How can you argue that the selloff doesn’t have further to go? We hear the manufactured/manipulated argument a lot but we do not believe that the data support it. The advance in the S&P 500 since January 1, 2008 (Chart 4, top panel) has comfortably surpassed nearly everyone’s contemporaneous expectations and we do not dispute that ample monetary accommodation played a large part in smoothing the way for the US economy’s comparatively rapid recovery. In our view, however, the boost to the economy, as proxied by the potent rise in expected S&P 500 earnings (Chart 4, middle panel), was more important than investors’ increased willingness to pay up for them (Chart 4, bottom panel). Rebasing both series to 100 as of January 1, 2008 shows that consensus earnings estimates have risen by four more times than forward multiples since the onset of the global financial crisis. A similar analysis obtains for the current pandemic era, especially now that the S&P 500’s forward multiple has dipped back below its January 1, 2020 level (Chart 5, bottom panel). The index’s annualized 9.7% return has surpassed most investors’ wildest hopes when stocks were crumbling in the middle of March 2020 (Chart 5, top panel). The gain is entirely attributable to the 12.9% annualized increase in consensus earnings expectations (Chart 5, middle panel). Lavishly generous fiscal and monetary accommodation deserves the credit for the earnings snapback. Though excessive aid may eventually cause the economy to overheat, we disagree with the idea that the pandemic rally has been built on a house of monetary stimulus cards. Chart 4Earnings Have Driven The Post-Crisis ...​​​​​​ Chart 5... And Post-Pandemic Bull Markets​​​​​​ An Index Valuation Model Where do you think the S&P 500’s forward multiple should be right now? Although no one should expect that any given financial instrument should trade at its fair value at any particular moment in time, it is useful to have approximate fair value estimates to gauge assets’ relative attractiveness and future return prospects. To apply some quantitative rigor to answering this question, we set out to build a regression model that would point the way to an appropriate valuation range. We started with the 10-year Treasury yield as our first independent variable and examined various inflation, equity sentiment and consumer sentiment series to discover other variables that could enhance its explanatory powers. To most nearly isolate the multiple impact, we passed over measures of economic activity for variables that would not be expected to exert an equal or greater impact on S&P 500 earnings. Inflation measures in themselves failed to contribute to the cause, but inflation expectations series proved more availing. None of the major equity sentiment surveys nor BCA’s composite sentiment indicator contributed to the other variables’ explanatory power. Consumer confidence surveys showed some promise, and the difference in the Conference Board’s Jobs Plentiful/Jobs Hard to Find series performed the best in backtests. Much to our surprise, the 10-year Treasury yield lost its statistical significance along the way and we duly jettisoned it, leaving us with a model that regressed the index forward multiple against the exponentially smoothed long-run moving average of measured inflation used by our fixed income strategists to assess Treasury fair values and the net Jobs Plentiful measure. Chart 6 shows the historical path of the S&P 500’s forward four-quarter earnings multiple and the fitted value from our regression. The backtested fit is quite good, as befits the model’s 72% r-squared. Encouragingly, the model suggests that the de-rating has gone too far. It returned an 18.5 value at the end of April, a full point above the actual 17.5 reading and nearly two points above the 16.7 multiple as of Wednesday’s close. Chart 6Estimating What The S&P 500's Forward Multiple Should Be We take any modeled point estimate with a grain of salt and are dyed-in-the-wool skeptics about any quantitative model’s persistence as a practical investment guide. We nonetheless performed this modeling exercise to provide a quantitative historical basis for estimating the fair value of the S&P 500’s forward multiple. The fact that we threw the 10-year Treasury yield overboard does not invalidate Chart 2; multiples and long-maturity yields are plainly inversely related, but our internal inflation expectations measure apparently conveys all of the 10-year yield’s information about the forward multiple’s historical moves and then some. Like every conscientious evidence-based researcher, we will go wherever the data lead us, independent of any preconceptions we might bring to a particular study. The Road Ahead When will the selloff end? We don’t know the date, the time or the level at which the equity selloff will eventually end. If our view that earnings will hold up is correct, however, the answer will turn on when the de-rating ends. The equity risk premium, a simple regression against the level of long Treasury yields and a multi-factor regression incorporating BCA’s proprietary inflation expectations model and consumers’ perceptions of the jobs market all suggest that de-rating has gotten ahead of itself. A 23% haircut over four-and-a-half months seems extreme when we think an adverse inflection point is over a year away. We have never counted on settling down with TINA, figuring that it wasn’t her nature to stick around for the long haul. Sentiment is fickle, and one day investors will discover that she’s left without a by-your-leave. Despite the upheaval so far this year, however, we think equities still hold considerable relative allure. With inflation mauling the value of cash holdings and high-duration bonds, one could argue that the alternatives to equities are even less appealing than they were when she first appeared on the scene. Our Global Investment Strategy service tactically upgraded global equities to overweight from neutral two weeks ago and we are more inclined to add equity exposure than reduce it when we revisit our ETF portfolio holdings in next week’s month-end report. There is no shortage of obvious concerns from Beijing to Moscow to Bentonville, Arkansas, but we think the factors that could go right are getting short shrift. Russian forces bogged down in eastern Ukraine are less likely to pursue expanded military adventures, reducing the potential that western Europe and the US could be drawn into a larger conflict. China’s zero-COVID policy may be doomed to futility, but headway on domestic production of an mRNA vaccine and the global ramp-up of anti-viral medication production could limit future outbreaks’ impact on the supply chain. The bottom line is that we remain constructive over the cyclical 3-to-12-month timeframe, while sharing the house view that the tactical equity outlook has improved. If the backup in bond yields has run its course for the time being, we expect that equity de-rating has as well. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Executive Summary Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets.      After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Chart 2Low-Income Households Are At Risk Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Chart 4European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies.  An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Chart 12Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium Chart 14The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022.  We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report  European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks.    Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Indian Voter’s Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Chart 11India’s Debt Levels Are High And Rising It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Chart 4Wage Pressures May Be Starting To Ease Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Chart 9When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock   Chart 20B... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Listen to a short summary of this report.     Executive Summary EUR/JPY And The DXY: Unsustainable Gap Three interrelated themes are likely to play out by the end of 2022 – peak Fed hawkishness, continued central bank convergence, and nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet through a short EUR/JPY trade, a corresponding play on the second theme. Betting on nascent green shoots in economic growth can be expressed via a long Aussie position, or more prudently, a short CHF/SEK bet. We are long a CAD and NOK basket against the RUB, a play on an eventual recovery in oil demand, and the premium that these blends will continue to command relative to Russian oil. Finally, most of our trades remain at the crosses due to elevated FX volatility which has boosted safe-haven demand for the dollar. The admission of Sweden and Finland into NATO could increases the risk of miscalculation on the part of Russia, which will continue to prop near-term safe-haven demand for the dollar. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 133.28 2022-05-12 -0.73 Bottom Line: Continue to focus on relative value trades at the crosses, until signs emerge that FX volatility is peaking, which will be more conducive for direct USD bets. Feature Chart 1Dollar Capitulation Occurs At Record Valuation And A Record Deficit Last week’s report focused on the key reasons why longer-term investors should begin to fade dollar strength. For one, the dollar already imbeds a hefty safe-haven premium. This premium manifests itself in an overvalued exchange rate (Chart 1). A simple PPP model shows that the dollar is overvalued by 27%. This is higher than the peak in the US dollar which preceded the bear market that began in the early 2000s. While valuations tend to matter little until they trigger a tipping point, such an inflection point could be around the corner. One catalyst has been the widening trade deficit which needs to be financed via foreign capital inflows. The US trade deficit continues to deteriorate, hitting a record low of $109.8bn in March. Over the last few years, it has become increasingly difficult to fund this widening trade deficit through foreign purchases of US Treasuries. That said, FX markets are likely to focus on three interrelated themes in the near term – peak Fed hawkishness, continued central bank convergence, and the potential for nascent green shoots in global economic growth. We are playing the first theme via an outright short DXY position. We are also hedging this bet with a short EUR/JPY trade, a corresponding play on the second theme. In the next few sections, we go through a few trades that would benefit from these themes.   Short EUR/JPY: A Defensive Play Most of our trades in the portfolio are pro-risk.  As such, a short EUR/JPY position acts as an attractive hedge in the near term. The DXY index has historically traded in perfect inverse correlation to the euro-yen exchange rate, but an unusually wide gap has opened up (Chart 2). In our view, this suggests that the collapse in the yen, relative to the euro, is very much overdone. In a risk-off environment, as we witnessed on Wednesday, EUR/JPY will sell off. Meanwhile, there are also fundamental reasons to suggest that this cross is stretched on a longer-term time horizon. First, the cross is expensive on a PPP basis. Chart 3 shows that EUR/JPY usually peaks when the real effective exchange rate is 1.5 standard deviations above its long-term mean. Today’s valuation pins it close to that, among the highest levels since the 1980s. Standard economic theory suggests that a reversal in the cross will be warranted to realign euro area competitiveness relative to Japan. Chart 2EUR/JPY And The DXY: Unsustainable Gap Chart 3EUR/JPY Is Not Cheap Meanwhile, there is a case to be made that an expensive EUR/JPY exchange rate is already affecting relative competitiveness. European exports are relapsing relative to those in Japan, which usually ensues after a period of euro-yen strength. Case in point: German factory orders are already contracting, while machinery orders in Japan remain relatively robust (Chart 4). Second, the European Central Bank has been relatively hawkish, vis-à-vis the Bank of Japan. The yield on December 2022 Euribor contracts is 78bps above the TIBOR equivalent, suggesting the ECB will hike rates 4-5 times this year versus the BoJ. Granted, inflation is overshooting in Europe relative to Japan (Chart 5). But as we have been witnessing around the world from the UK to Canada, and all the way to Australia, rising inflation is a global problem. If it persists, it will also begin to meaningfully show up in the Japanese numbers. This will nudge the BoJ away from the ultra-dovish camp.  More likely, inflation will moderate, which will allow the ECB to dial back its hawkish rhetoric. Chart 4Europe Is Losing Competitiveness To Japan Chart 5Eurozone Inflation Could Subside In The Coming Months Even if inflation moderates in the eurozone, short-term real rates will remain deeply negative compared to Japan. This will be a significant drag for relative fixed income flows and the currency (Chart 6). At the same time, higher inflation in Europe also suggests the fair value for EUR/JPY should continue its structural downtrend. Chart 6Real Rates Are Very Low In The Eurozone Third, oil price volatility will remain high in the near term but will subside longer term. We are cognizant of the fact that, our Chief Commodity Strategist, Robert Ryan, expects the geopolitical risk premium in oil to increase in the near term. When rising oil coincides with rebounding economic activity, the yen tends to lag as a defensive currency (Chart 7). This time around, the premium in energy markets has come from a cutoff in Russian supplies. Japan imports almost all its energy and has structurally been more dependent on fossil fuels than Europe (Chart 8). This has boosted EUR/JPY and is a risk to a short position. Chart 7EUR/JPY Tracks Oil Chart 8Japan Will Accelerate A Shift From Fossil Fuels That said, adjustments are already underway. Japanese and European LNG imports from the US are rising. As a result, the price arbitrage between US Henry Hub prices and the Dutch TTF equivalent are collapsing (Chart 9). The Japanese have already ramped up nuclear power production, reducing their dependence on fossil fuels (Chart 10). That will be a welcome fillip for the Japanese trade balance. In a nutshell, a lot of bad news is already priced in the yen. As such, it has become an attractive hedge. Asian clients not willing to short the euro can short CNY/JPY as a close proxy. Interestingly, CNY/JPY has made a classic double-top and could meaningfully depreciate from current levels (Chart 11), along with EUR/JPY. Chart 9The European And Asian Natgas Premium Is Deflating Chart 10A Nuclear Renaissance In Japan? Chart 11CNY/JPY: A Double Top? Short CHF/JPY: Still Attractive, But Taking Profits We also played a long yen leg via a short CHF position but our trailing stop was triggered this week at 130 for a profit of 3.74%. While we believe the cross still faces meaningful downside, we will opportunistically look to sell CHF/JPY again at 135. First, historically, CHF/JPY has inversely tracked the inflation profiles between Switzerland and Japan. Given the collapse in the yen, and much higher Swiss inflation, CHF/JPY has become incrementally more expensive, especially relative to history (Chart 12). To realign competitiveness, the cross should depreciate. Second, from a technical perspective, CHF/JPY is in a classic double-top formation (Chart 13), akin to CNY/JPY. This suggests the safe-haven premium is much higher in the franc than it is in the yen.    Chart 12Swiss Inflation Is Lowering CHF"s Puchasing Power Chart 13CHF/JPY: Look To Go Short Again The key risk to this trade is that the Swiss equity market is more defensive relative to Japanese bourses. As such, the hefty safe-haven premium in the franc could persist (Chart 14), pushing the cross to our initial entry short point at 135. Chart 14Swiss Equities Could See Inflows Near Term Short CHF/SEK: A Play On The Riksbank’s U-Turn Chart 15Short CHF/SEK Is The Great Value/Growth Play Value/Growth Turns Before The Dollar Last month, we argued that the dip in the Swedish krona had already priced a recession in the domestic economy. Meanwhile, with a mandate of price stability, we argued the Riksbank will have no choice but to turn more hawkish or lose credibility. As a play on this trend, we recommended going long the SEK relative to the CHF. In a major policy U-turn, the Riksbank raised rates and announced a faster pace of balance-sheet reduction. Most of the arguments made in the original report remain valid, so we will not revisit them here. The one point we will stress is that Sweden’s small open economy makes the SEK very sensitive to global economic conditions. One benefit of a short CHF/SEK position is that while value has been outperforming growth during this selloff, CHF/SEK remains strong which is a departure from the traditional relationship (Chart 15). Ergo, a major safety discount is imbedded in the SEK. Related Report  Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar Sweden’s bourse is heavy in cyclicals, with large overweight positions in financials and industrials, that will benefit from a renewed capital spending cycle, and higher global rates. Meanwhile, the outperformance of value during a market riot point suggests a change in market leadership could be underway, even if bond yields temporarily crater. The krona remains vulnerable to geopolitical risk, especially if Russia retaliates against Sweden and Finland joining NATO.  So far, Russia’s response has been muted. As such, while this pro-cyclical trade faces near-term risk, it remains a safer way, in our view, to play SEK strength. Long AUD: Bet On An Eventual China Rebound Chart 16The AUD And China We will be discussing Australia in an in-depth report next week, so we will keep our comments brief this week. What we will say is that the Aussie is one of the best candidates to play a rebound in global growth, given that it sits near the epicenter of where that growth will likely emanate from – China (Chart 16). Right now, the picture is not pretty, but it is always dark before dawn. Stay tuned. Long (CAD+NOK)/RUB: A Relative Value Play As many countries reroute their oil supplies from Russia to other countries, Canada and Norway could stand to benefit from a relative perspective. Understandably, many clients might not be able to trade the RUB, so we are filing this trade under speculative. First, both Brent and Western Canadian Select oil are trading at a significant premium to the Urals blend, which is likely to be sustained in the next 6 months. This will benefit NOK and CAD, relative to the ruble (Chart 17). Chart 17CAD And NOK Will Benefit From Premium Oil Second, from an FX point of view, Russia faces the trilemma of the impossible trinity – having decided to limit the free flow of capital, it has chosen independent monetary policy and managing the exchange rate. This will come at a cost, however: As the economy comes grinding to a halt and inflation surges, interest rates will have to stay high to maintain currency stability. This will crush the domestic economy for years to come. Luckily, Russia has a healthy current account surplus, but as production in Canada and Norway improve to offset embargoes on Russian crude, this will also boost their external balance. Long EUR/GBP: The Euro Is More Priced For A Recession We have discussed at length the rationale behind our long EUR/GBP position, so we will not reiterate the arguments here. Our Global Fixed Income colleagues upgraded Gilts to overweight last week, in line with expectations that markets will continue pricing a dovish tilt from the BoE. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. As such, if interest rates in the UK continue to fall relative to those in the eurozone, EUR/GBP will benefit (Chart 18). Chart 18EUR/GBP Has Upside Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Fed will continue to hike rates at a time when global trade is contracting. Earlier this week, Fed Chairman Jerome Powell reiterated that the Fed will not hesitate to hike rates until core consumer price inflation gets closer to 2%. Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Besides, according to Powell, US financial conditions are not yet at a level that is consistent with inflation coming down substantially. China will stick to its dynamic zero-COVID policy this year. The economy will continue to underwhelm as the magnitude and nature of stimulus measures announced thus far are not adequate to produce a recovery. Industrial metal prices and global material stocks are at risk of gapping down. Play these markets on the short side. Commodity Currencies Are Signaling Lower Commodity Prices Bottom Line: It is still dangerous to bottom fish in global equities and risk assets in general. The US dollar has more upside. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Feature The risks to global and EM risk assets are still skewed to the downside. Although investor sentiment on global equities has soured of late, we do not think global or EM equities have made a bottom, and the US dollar has not yet reached an apex. Consequently, absolute-return investors should stay defensive, and global equity portfolios should continue to underweight EM stocks. The Fed and Equities Are Still On A Collision Course Earlier this week, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation”… “We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Chart 1US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now Chart 1 shows the average of core median CPI, core trimmed-mean CPI and core sticky CPI, which are better indicators of genuine inflationary pressures because they are less affected by outliers. Even though core CPI inflation ticked down in April, other core measures such as core median CPI, core trimmed-mean CPI and core sticky CPI continued to rise. These core inflation measures are not likely to ease back to 2% unless economic growth falls below its potential. In his same speech, Chairman Powell also asserted: “We will go until we feel like we are at a place where we can say, ‘Yes, financial conditions are at an appropriate place. We see inflation coming down.’ We will go to that point, and there will not be any hesitation about that.” This means that US financial conditions have not yet tightened enough for the Fed to back down on its hawkishness. Finally, we have been arguing that a wage-price spiral has developed in the US as the labor market has become very tight (Chart 2, top panel). Wages and unit labor costs have been surging. Unit labor costs are the most important driver of US core CPI (Chart 2, bottom panel). Therefore, it will be impossible for the Fed to bring down core inflation toward 2% without a retrenchment in the labor market, i.e., layoffs. Rising unemployment will in turn weigh on household income growth and consumption. Chart 2The US Labor Market Is Very Tight And Wage Growth Is Accelerating The cost of borrowing for companies is rising globally, and these periods often coincide with equity selloffs. Notably, surging US high-yield ex-energy corporate bond yields herald lower US share prices ahead (Chart 3, top panel). Similarly, rising EM corporate bond yields foreshadow a further decline in EM ex-TMT share prices (Chart 3, bottom panel). Chart 3Rising Corporate Bond Yields Are Bearish For Stocks On the whole, the Fed and many other central banks will be hiking interest rates at a time when global trade volumes are contracting in H2 2022. As discussed in our report A Whiff Of Stagflation? US and EU imports of consumer goods are set to shrink following the pandemic boom. Chart 4Global Export/Manufacturing Are Heading Into Contraction Meantime, rolling lockdowns and extremely weak income growth are depressing domestic demand in China. High food and energy prices as well as rising interest rates are weighing on EM ex-China consumption. The sharp underperformance of global cyclicals equities versus global defensive sectors corroborates our expectation that global manufacturing activity will contract (Chart 4). The trade-weighted US dollar typically benefits from both Fed hikes and a global trade slump. As long as the Fed is hawkish and global exports are contracting, the greenback will continue to appreciate. For now, the US dollar remains in a strong position for further appreciation, especially versus EM currencies (Chart 5). Consistently, the selloff in broad EM risk assets is not yet over.  Chart 5EM Currencies: More Downside A major reversal in the trade-weighted dollar will be a signal that the global macro backdrop is improving and that global share prices and EM risk assets are bottoming. Bottom Line: Although equities have become oversold and investor sentiment is depressed, any rebound will prove to be short lived. The Fed will continue to hike rates at a time when global trade is about to shrink. The global/EM equity selloff has further to run. China: Ordinary Stimulus Despite Extraordinary Conditions Only one thing is currently certain in China: authorities are committed to the dynamic zero-COVID policy. However, most experts outside China believe that it will be very difficult to wholly limit the spread of the easily transmissible Omicron variants, even with such stringent mainland containment policies. As a result, rolling lockdowns are the most likely scenario for China’s regions and cities in 2022. These lockdowns will depress household income, confidence and consumption. Private business investment and hiring will also tank. Have authorities provided enough stimulus to support a recovery in H2 2022? We do not think so. Chinese stimulus has so far been ordinary in nature and in magnitude. Policy easing will likely prove to be insufficient to lift the economy out of the current extraordinary slump. First, Chinese exports are set to shrink in H2 as US and EU consumption of consumer goods revert to their pre-pandemic trend. Demand from EM will remain weak. Second, rising unemployment and under-employment is hindering household income. Generous cash transfers are needed to offset this hit to income. Not only did aggregate retail sales collapse in April, but online sales of goods and service also plunged (Chart 6). It is hard to imagine that private businesses will be investing when consumer spending and exports are weak. Our proxies for the marginal propensity to spend for households and enterprises continue to fall (Chart 7). Chart 6China: Even Online Retail Sales Are Shrinking Chart 7China: Household And Enterprise Propensity To Spend Have Been Declining   Critically, China’s credit impulse, excluding government bond issuance, remains in negative territory (Chart 8). Third, China’s property market is frail. Despite modest policy easing for the real estate market, sentiment among home buyers and developers remains downbeat. Given that the housing sector faces structural headwinds, odds are that buyers and developers might not react to the modest property market easing that authorities have so far provided. It is worth noting that Chinese property stocks seem to have had a structural breakdown, and offshore corporate bonds of real estate developers remain in a bear market (Chart 9). These market patterns corroborate that China's housing market has experienced a structural breakdown. Chart 8Chinese Stimulus Has So Far Been Tame Chart 9Chinese Property Market Has Experienced A Structural Breakdown   Finally, even though infrastructure spending is being ramped up, it will prove to be insufficient for the economy to recover from a deep slump. Local governments are facing a major financing shortfall. Land sales – which make up about 40% of local government revenues – have dried up. This will hinder local governments’ ability to finance infrastructure projects. As to Chinese equities, internet/platform stocks have become oversold. However, their long-term outlook remains dismal. As we have been arguing since late 2020, the fundamental case for their de-rating remains intact. This week’s meeting between government officials and technology companies has not produced any positive news. Although the tone from authorities was more balanced, they did not offer any relief from already imposed regulations. Chart 10Implications Of China's Common Prosperity Policies Looking forward, implementing common prosperity policies will be the primary objective of the Communist Party in the coming years. These policies will assure that labor’s share of income will rise further at the expense of corporate profits. Chart 10 demonstrates that the share of labor in national income has been rising since 2011. Conversely, the share operating profits peaked in 2011 and has dropped to a 30-year low. These dynamics will persist as income will continue to be redistributed from shareholders to labor in the majority of industries/companies in China. This is an unfriendly outlook for shareholders, especially foreign ones. Bottom Line: Chinese policy stimulus has so far been insufficient. The economy is in a deep slump, and share prices remain at risk of further decline. Short Industrial Metals And Material Stocks Chart 11Chinese Imports Of Metals Was Shrinking In 2021 Industrial metals’ resilience last year in the face of shrinking Chinese import volumes was unusual (Chart 11). This resilience was probably due to robust DM demand for goods, supply bottlenecks and investors buying commodities as an inflation hedge. As we elaborated in the April 28 report, risks to industrial metals are skewed to the downside. This is despite the fact that agriculture prices will likely rise further, and energy prices will remain volatile due to the geopolitical situation. We continue to recommend investors underweight/short materials stocks and industrial metals for the following reasons: It is ill-advised to play the US inflation story by being long industrial metals and materials stocks. As shown in Chart 2 above, US unit labor costs are driving core inflation, not industrial metals. China accounts for 50-55% of global industrial metal consumption, and since early 2021 the key risk in China has been decelerating demand/deflation not inflation. In fact, commodities have become a crowded hedge against inflation and a global growth slowdown poses a substantial risk to industrial metals. Chart 12 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding energy). Chart 12Chinese Material Stocks Are Signaling Trouble For Global Materials When share prices of customers are falling, equity prices of suppliers will likely follow. Chart 13 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed raw material prices to two standard deviations above this long-term trend. Chart 13Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 13 does not include energy, gold and semi-precious metals. Finally, shrinking global trade volumes are also negative for raw materials. The average of AUD, NZD and CAD points to lower industrial metal prices (Chart 14). Chart 14Commodity Currencies Are Signaling Lower Commodity Prices Chart 15Bearish Technical Patterns: BHP Share Price And Copper The share price of BHP, the world’s largest mining company, has put in a major top and is now gapping down (Chart 15, top panel). Copper prices have broken below their 200-day moving average that served as a support in the past 12 months (Chart 15, bottom panel). These market profiles point to more downside. We continue to recommend that investors play this theme in the following ways: Short copper or short copper / long gold; Short global materials / long global industrials; Short ZAR / long USD. Also, we downgraded Brazil early this week  partly due to expectations of lower iron ore prices and souring investor attitude toward commodity plays in general. Investment Conclusions Global and EM equities have entered a capitulation phase. It is still dangerous to bottom fish in global equities and risk assets in general. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. The US dollar has more upside. Continue shorting the following EM currencies versus the USD: ZAR, PLN, HUF, COP, PEN, PHP and IDR. As we discussed in a recent report, we are approaching a major buying opportunity in EM local currency bonds. However, the US dollar needs to peak for that to transpire. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 17 at 9:00 AM EDT, 14:00 PM BST, 15:00 PM CEST and May 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

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