Fixed Income

Highlights 2022 Key Views & Allocations: Translating our 2022 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions to begin the year. Target a moderate level of overall portfolio risk, maintain below-benchmark overall duration exposure, make developed market government bond country allocations based on relative expected central bank hawkishness (underweight the US, UK and Canada; overweight Germany, France, Italy, Australia, Japan), and be selective on allocations to global spread product (overweight high-yield with a bias toward Europe over the US, neutral global investment grade, underweight emerging market hard currency debt). Specific Allocation Changes: Much of the current positioning in our model bond portfolio already reflects our 2022 investment themes. The only significant changes we make to begin the year are reducing emerging market USD-denominated corporate bond exposure to underweight, and shifting some high-yield corporate bond exposure from the US to Europe. Feature In our last report of 2021, we published our 2022 Key Views, outlining the themes and investment implications of the 2022 BCA Outlook for global fixed income markets. In this report, our first of the new year, we translate those views into more specific recommendations and allocations within the BCA Research Global Fixed Income Strategy model bond portfolio. The main takeaways are that another year of expected above-trend global growth, even after the risks to start the year from the Omicron variant, will further absorb spare capacity across the developed economies. Realized inflation will slow from the elevated readings of 2021, but will remain high enough to force central banks – led by the US Federal Reserve – to incrementally remove highly accommodative monetary policies put in place during the pandemic. The backdrop for global bond markets will turn far less friendly as a result, with higher bond yields (led by US Treasuries), flatter yield curves and much weaker returns on spread products that have benefited from easy monetary policies like investment grade corporate debt and emerging market (EM) hard currency debt. Against this challenging backdrop for overall fixed income returns, bond investors will need to focus more on relative exposures between countries, sectors and credit ratings to generate outperformance versus benchmarks. Our recommended portfolio allocations to begin 2022 reflect that shift (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The Model Bond Portfolio Performance In 2021 Chart 12021 Performance: A Positive, Yet Volatile, Year Before we begin our discussion of the model bond portfolio for 2022, we will take a final look back at the performance of the portfolio in 2021. Last year, the model bond portfolio delivered a small negative total return (hedged into US dollars) of -0.51%, but this still outperformed its custom benchmark index by +36bps (Chart 1).1 It was a very challenging year for global fixed income markets, in aggregate, with significant swings in bond yields (i.e. US Treasuries were up in Q1, down in Q2/Q3, up then down in Q4) and credit spreads (US high-yield spreads fell in H1/2021 and were rangebound in H2/2021, while EM hard currency spreads were stable in H1/2021 before steadily widening during the rest of the year). Over the full year, the government bond portion of the portfolio outperformed the custom benchmark index by +27bps while the spread product segment outperformed by +9bps (Table 2). The bulk of that government bond outperformance occurred during the first quarter of the year when global bond yields surged higher as COVID-19 vaccines began to be distributed and economic optimism improved in response – trends that benefited the below-benchmark duration tilt within the portfolio. The credit market outperformance was more evenly spread out during the final nine months of the year. Table 2GFIS Model Bond Portfolio Full Year 2021 Overall Return Attribution In terms of specific country exposures on government debt (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) generated virtually all of the full-year outperformance of the government bond portion of the portfolio (+38bps versus the benchmark). The biggest underperformer was the UK (-9bps), concentrated at the very end of the year as Gilt yields declined on the back of the Omicron surge, to the detriment of our underweight stance. All other country allocations provided little excess return, in aggregate, over the full year in 2021 – although there was significant variance of those returns during the year. Within spread product (Chart 3), the biggest gains were seen in US high-yield (+19bps) where we remained overweight throughout 2021. The largest drag on performance came from UK investment grade corporates (-9bps), although this all came in Q1/2021 where we maintained an overweight stance at the time and spreads widened. Other spread product sectors delivered little in the way of excess return, although that should not be a surprise as we maintained a neutral stance on US and euro area investment grade corporates – which have a combined 18% weighting within the model bond portfolio custom benchmark index – throughout 2021. In the end, our recommended portfolio tilts during 2021 were generally on the right side of the market, with our overweights outperforming in an overall down year for bond returns (Chart 4). The numbers would have been even better without the drag on performance in the fourth quarter (-17bps for the entire portfolio). That came entirely from our two biggest government bond underweights – US Treasuries and UK Gilts – which saw significant bond yield declines in response to the emergence of the Omicron variant. (the detailed breakdown of the Q4/2021 performance can be found in the Appendix on pages 19-23). Importantly, the surge in bond yields seen in the first week of 2022 has already resulted in a full recovery of that Q4/2021 underperformance, providing a good start to the new year for our model portfolio. Top-Down Bond Market Implications Of Our Key Views We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: BELOW BENCHMARK As we concluded in our 2022 Key Views report, longer-maturity government bond yields are now too low given the mix of very high inflation and very low unemployment seen in many countries. While we expect inflation to come down this year from the very rapid pace of 2021, it will not be by enough to force central banks off the path towards rate hikes that already began at the end of last year in places like the UK and New Zealand. The Fed is now signaling that multiple US rate hikes are likely in 2022, while even some European Central Bank (ECB) officials are expressing concern over very high European inflation. Longer maturity bond yields remain too low, in our view, because investors are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. (Chart 5). An upward adjustment of global interest rate expectations is likely this year as central banks like the Fed and the Bank of England (BoE) deliver on expected rate hikes, with more tightening necessary beyond 2022. This will be the primary driver of the rise in global bond yields that we expect this year - an outcome that has already begun in the first week of 2022. Chart 5Global Government Bond Yields Vulnerable To Hawkish Repricing​​​​​​ Chart 6Staying Below-Benchmark On Overall Duration Exposure​​​​​​ We ended 2021 with a model bond portfolio duration that was -0.65 years below that of the custom performance benchmark (Chart 6). We feel comfortable maintaining that position, in that size, to begin the new year. Government Bond Country Allocation: OVERWEIGHT THE EURO AREA (CORE & PERIPHERY), JAPAN & AUSTRALIA; UNDERWEIGHT THE US, UK & CANADA Our country allocation decisions within our model bond portfolio entering 2022 are based on a simple framework. We are overweighting countries where central banks are less likely to raise rates this year, and vice versa. We expect the largest increase in developed market bond yields in 2022 to occur in the US, as markets are still not priced for the cumulative tightening that the Fed will likely deliver over the next couple of years. Markets are also underpricing how much the Bank of England and Bank of Canada will need to raise rates over the full tightening cycle, even with multiple hikes discounted for 2022. We see the necessary upward repricing of post-2022 rate expectations in all three of those countries – the US, UK and Canada – justifying underweight allocations in our model portfolio. Chart 7Our Recommended DM Government Bond Allocations To Start 2022 The opposite is true in core Europe and Australia. Overnight index swap (OIS) curves are discounting multiple rate hikes this year from the Reserve Bank of Australia (RBA) and even an ECB rate hike later in 2022. As we discussed in our Key Views report, there is still not enough evidence pointing to rapid wage growth in Australia or Europe that would force the RBA and ECB to turn more hawkish than their current forward guidance which calls for no rate hikes in 2022. While both central banks may talk about the possibility that monetary policy will need to be tightened, we expect the actual rate hikes to occur in 2023 and not 2022. Thus, both markets justify overweight allocations in our model bond portfolio. We are also maintaining an overweight to Japanese government bonds, as Japanese inflation remains far too low – even in an environment of high energy prices and global supply chain disruption – for the Bank of Japan to contemplate any tightening of monetary policy. The country allocations within the model portfolio as of the end of 2021 all fit with the above analysis, thus we see no major changes that need to be made to begin 2022 (Chart 7).2 The only significant move made was to slightly bump up the size of the overweights in Italy and Spain, to be funded by the reduction in EM corporate bond exposure (as we discuss below). We continue to see a positive case for owning Peripheral European government bonds for the relatively high yields within Europe, with the ECB maintaining an overall dovish policy stance in 2022 even as it scales back the size of its bond buying activity starting in March. Inflation-Linked Bond Allocations: MAINTAIN A NEUTRAL OVERALL ALLOCATION TO GLOBAL LINKERS Chart 8Our Recommended Inflation-Linked Bond Allocations To Start 2022 Inflation-linked bonds have been a necessary part of bond investors' portfolios since the lows in global inflation breakeven spreads were seen in mid-2020. Now, with inflation expectations at or above central bank inflation targets in most developed market countries, and with realized inflation likely to subside from current levels this year, the backdrop no longer justifies structural overweights to linkers across all countries. We are sticking with our end-2021 overall neutral allocation to global inflation-linked bonds, focusing more on country allocations based on our inflation breakeven valuation indicators, as discussed in our 2022 Key Views report (Chart 8). This means maintaining a neutral stance on US TIPS and linkers (vs. nominal government bonds) in Canada, Australia and Japan. We are also staying with underweight positions in linkers (vs. nominals) in the UK, Germany, France and Italy where breakevens appear too high based on our indicators. Spread Product Allocation: MAINTAIN A SMALL OVERWEIGHT TO GLOBAL SPREAD PRODUCT FOCUSED ON EUROPEAN & US HIGH-YIELD CORPORATES, WHILE UNDERWEIGHTING EM CREDIT Chart 9Negative Real Yields: Global Bonds' Biggest Vulnerability Our expectation of above-trend global growth in 2022, with still relatively high inflation (compared to pre-pandemic levels), should be positive for spread products like corporate bonds that benefit from strong nominal economic (and revenue) growth. However, the less accommodative global monetary policy backdrop we also expect is a potential negative for credit market performance - specially as rate hikes put upward pressure on deeply negative real interest rates, most notably in the US (Chart 9). Thus, we are entering 2022 with a cautious, but still positive, overall position on spread product in our model bond portfolio. We are focusing more on credit valuation, however - both in absolute terms and between countries and sectors – to try and generate outperformance for the credit portion of the portfolio. We are maintaining a neutral stance on investment grade corporates in the US, euro area and UK given the tight spread valuations in those markets. We prefer to focus our corporate credit exposure on overweights to high-yield bonds in the US and Europe, but with a marginal preference for European junk bonds over US equivalents as we discussed in our 2022 Key Views report (Chart 10). Within EM USD-denominated credit, we remain cautious entering 2022 given the poor fundamental backdrop for EM credit: slowing momentum of Chinese economic growth and global commodity prices, a firmer US dollar, and a less-accommodative global monetary policy backdrop (Chart 11). Thus, an underweight stance on EM credit is appropriate within the portfolio to start the year. Chart 10Increase Euro High-Yield Exposure Vs US High-Yield Chart 11Reduce EM USD-Denominated Corporate Debt Exposure To Underweight​​​​​​   Finally, we are entering 2022 with the same relative tilt within US mortgage-backed securities (MBS) that we maintained during the latter half of 2021, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Based on our outlook for 2022, we are immediately making two marginal changes to the spread product allocations to the model bond portfolio: Reducing the size of our US high-yield overweight and using the proceeds to increase the size of the European high-yield overweight Reducing our EM USD-denominated corporate bond allocation to underweight from neutral, and placing the proceeds into Italian and Spanish government bonds (hedged into USD) to limit the reduction in the portfolio yield from the EM downgrade. The above moves will lower our overall credit overweight versus government bonds from 5% to 4%, all coming from the EM to Italy/Spain switch (Chart 12). Overall Portfolio Risk: MODERATE The changes made to our spread product allocations had no material impact on the estimated tracking error of the model portfolio – the relative volatility versus that of the benchmark. The tracking error is 78bps, still below our self-imposed limit of 100bps but above the lows seen in early 2021 (Chart 13). That higher tracking error is likely related to our underweight stance on US Treasuries, given the rise in bond volatility evident in measures like the MOVE index (bottom panel). Nonetheless, a moderate level of portfolio risk is reasonable given the combination of solid global economic growth, but with tighter global monetary policy, that we expect in 2022. Chart 13Keeping Overall Portfolio Risk At Moderate Levels​​​​​​ Chart 14Positive Portfolio Carry Via Selective Spread Product Overweights​​​​​​ The overweights to US high-yield, European high-yield and Italian government bonds all contribute to the model bond portfolio having a yield that begins 2022 modestly higher (+14bps) than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making all the changes to our model portfolio allocations, which can be seen in the tables on pages 24-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio during the first half of 2022. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case Omicron related economic weakness is visible in some major economies (euro area, Canada), but the US stays resiliently strong and the US labor market continues to tighten. China is a growth laggard, but this will lead to policymakers providing more macro stimulus (credit, monetary, fiscal) starting in Q2/2022. Inflation pressures from supply chain disruption remain stubbornly strong and realized global inflation rates stay elevated for longer. Developed market central banks continue dialing back pandemic-era monetary policy accommodation, led by Fed tapering and a June 2022 liftoff of the funds rate. There is a mild initial bear steepening of the US Treasury curve with additional widening of US inflation breakevens in Q1/2022, leading to bear flattening in Q2 in the run-up to liftoff – the net effect is a parallel shift higher in the entire yield curve. The VIX index stays near current levels at 20, both the US dollar and oil prices are broadly unchanged and the fed funds rate is increased to 0.25%. Hawkish Fed The Omicron wave is short-lived with limited impact on global growth, which remains well above trend. Global inflation only declines moderately from current elevated levels, both from persistent supply squeezes and faster wage growth. China loosens monetary/credit policies and announces new fiscal stimulus in late Q1/2022 – a positive surprise for global growth expectations. Developed economy central banks turn even more hawkish. Fed liftoff is in March, with another hike in June. The US Treasury curve bear-flattens as US inflation breakevens reach their cyclical peak. The VIX index climbs to 25, the US dollar depreciates by -3% (pulled in opposing directions by strong global growth but relatively higher US interest rates), oil prices climb +10% and the fed funds rate is increased to 0.5%. Pessimistic Scenario The Omicron wave persists in many major countries (including the US) and leads to extended lockdowns and weaker consumer spending. Global growth momentum slows sharply. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration passes much smaller US fiscal stimulus. Supply chain disruptions persist and are made worse by Omicron, keeping inflation elevated even as growth slows (stagflation). Developed economy central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to economic weakness. The Fed goes for a slower taper that still ends in June, but liftoff is delayed until at least September. The US Treasury curve bull steepens modestly as the front end prices out 2022 hikes. US inflation breakevens remain sticky due to persistent realized inflation. The VIX index climbs to 30, the US dollar appreciates by +5% on a safe haven bid, oil prices fall -10% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Chart 15Risk Factor Assumptions For The Scenario Analysis​​​​​ Chart 16US Treasury Yield Assumptions For The Scenario Analysis​​​​​ The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +54bps in the Base Case and +31bps in the Hawkish Fed scenario, but is projected to underperform by -9bps in the Pessimistic scenario. Importantly, there is virtually no expected excess return from the credit side of model bond portfolio in the Hawkish Fed scenario, even with strong global growth. A faster-than-expected pace of Fed rate hikes in the first half of 2022 would be a clear signal to downgrade exposure to the riskier parts of the fixed income universe like US high-yield. Although in that Hawkish Fed scenario, greater-than-expected China stimulus and a weaker US dollar would also represent signals to begin adding back emerging market credit exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We also made very slight adjustments within the US, Japan, Germany and France allocations to refine our allocations across the various maturity buckets while keeping the overall portfolio duration unchanged entering 2022. Appendix Recommendations Duration Regional Allocation Spread Product Tactical Trades 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

Highlights Chart 1Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

Highlights European economic activity will suffer in Q1 from both the Omicron wave and elevated natural gas prices. The Omicron wave will fade quickly and its impact on growth will be short lived. The biggest economic risk related to Omicron is inflation. Inflation is being caused by supply disruptions, a function of China’s zero-tolerance policy toward COVID. An ebbing of COVID will allow cyclicals to breakout relative to defensive equities in the second quarter. Buy banks / sell tech. For the remainder of the winter, European electricity will remain expensive because of elevated natural gas prices. This process creates a drag on growth and prevents the euro from recovering. European PMIs have not yet bottomed; however, they will do so in Q2. While French and UK economic activity has led Europe in recent months, Germany and the Netherlands are likely to continue to lag as the Omicron variant is only starting there. Italian and Spanish spreads have limited upside under these circumstances. Feature At the end of 2021, the European economy was hit by a spike in COVID-19 infections and another surge in natural gas prices. These shocks will continue to affect activity in the first few months of 2022. Understanding the evolution of these shocks will help investors find attractive entry points for the dominant trend that will play out for the remainder of the year. Omicron Spikes Chart 1Omicron Is Different COVID-19 cases are once again spiking across Europe because of the highly contagious Omicron variant. As Chart 1 shows, cases in the UK, France, Spain, and Italy have now eclipsed previous peaks. Cases in Germany and the Netherlands have declined recently, but this improvement reflects the ebbing Delta wave. These two countries are likely to follow the path of their European neighbors in relation to the Omicron variant. The Omicron wave will not have a lasting impact on European economic activity despite its frightening scale. Hospitalizations are rising, but they remain far from levels implied by the number of active cases in France, the UK, and Spain (Chart 1, third panel). Additionally, hospitalizations spans are shorter because the infection seems to be less virulent. Recent data out of France indicates that COVID-induced admissions in ICU are now around 18% with a median length of stay of three days, compared to roughly 30% and seven days in the previous waves. This more positive health outcome also reflects the benefit of elevated vaccination rates in the region. The evolution of the Omicron wave in South Africa also points toward a rapid turnaround of the COVID situation in Europe. Gauteng Province, where Omicron first became dominant, witnessed a sharp rise in new cases that declined less than four weeks after the outbreak began (Chart 1, bottom panel). The number of cases there thus seems to have reached its apex already. There are limited reasons to expect a different trajectory for the Omicron wave in Europe. This wave is also affecting individual behavior. Rules are now being developed to impose vaccinations on swath of the recalcitrant population in Italy and Austria, and the French president is openly defying anti-vaxxers by further limiting their daily lives. Vaccination rates are increasing and booster campaigns have rolled out successfully, as the UK illustrates. Finally, anti-viral drugs such as Pfizer Paxlovid will further limit the severity of infections of contaminated individuals. This background implies that the likelihood is low for long-lasting, severe lockdowns, such as those that prevailed in 2020 and in early 2021. As a result, the impact of the Omicron wave on economic activity and the labor market will be temporary and will wane before the end of Q1 2022. Chart 2Cyclicals Will Breakout... Eventually Financial markets have already adopted this view, as evidenced by European equities that rallied smartly through December—until the release of the Fed’s minutes last week spooked investors. We are inclined to agree with investors and look beyond the impact of COVID at the index level. Nonetheless, as long as the wave remains in place and economic activity bears its footprint, cyclicals will not break out relative to defensives (Chart 2). Omicron, however, is not without risks. China’s commitment to its zero-tolerance policy toward COVID-19 remains firmly in place, which may prove inflationary for the global economy. Entire cities such as Xi’an and Yuzhou have been pushed into lockdowns, and, if Omicron spreads further, more cities will suffer the same fate. If it is sufficiently widespread, then this process will produce global supply-chain bottlenecks again and renew pricing pressures, especially if it expands to Chinese port cities.  Investment Implications The first relevant market implication of a transitory Omicron shock is that, despite its violence and breadth, global markets will avoid a severe sell-off caused by plunging economic activity. As a corollary, cyclical stocks may continue to consolidate in the near-term against their defensive counterparts, but a breakout by the middle of 2022 remains highly likely. Chart 3Utilities Hate Ebbing Waves Tactical traders will also soon benefit from a short-term investment opportunity. Utilities have been outperforming in recent weeks as investors bid up defensive plays. However, the pattern of previous waves indicates that, as soon as this wave of cases peaks, utilities stocks will suffer a significant period of underperformance (Chart 3). Thus, short-term investors should sell European utilities once the seven days moving average of new cases peaks in the UK. Chart 4Banks To Outperform Tech The environment is also likely to remain favorable for banks relative to tech stocks in Europe. The recently released Fed minutes revealed that the FOMC has a strong hawkish bias and that the March meeting will be a live one. It also showed that, if Omicron proved to be inflationary because of its impact on supply chains, the Fed might be even more inclined to raise interest rates and cut its balance sheet size. Thus, a transitory Omicron shock to growth that is likely to have inflationary effects will contribute to higher yields. This will hurt tech stocks relative to banks, especially as European banks forward earnings are rising relative to the tech sector and their relative valuations are extremely favorable (Chart 4). Bottom Line: The number of COVID-19 cases in Europe is spiking rapidly, but we do not expect lengthy lockdowns to become the norm. As a result, the shock to growth caused by the Omicron variant will be ephemeral. Nonetheless, China’s health policy response points to some inflationary risks caused by supply bottlenecks. Investors should expect European markets to continue to take Omicron in stride and cyclicals to breakout later this year. Utilities are soon to be sold relative to the broad market and European banks will benefit at the expense of tech stocks. Natural Gas Remains The Euro’s Foe Chart 5Natural Gas Prices Are High And Volatile Dynamics in the European natural gas market remain a major risk for European economic activity and European currencies over the course of the first quarter of 2022. Natural gas prices on the Title Transfer Facility in the Netherlands spiked to a record close of EUR181/MWh on December 21, 2021, as tensions with Russia rose in Ukraine. Since then, Dutch natural gas prices—the continental European benchmark—have declined by 46% (Chart 5). The following combination of factors explains this sharp retrenchment: Europe, France, and Germany in particular have enjoyed exceptionally clement weather in recent days, stifling demand for heat and electricity. 11 LNG tankers from the US have been rerouted toward Europe, accounting for 800,000 tonnes of natural gas. Tensions between Russia and the West have eased somewhat. Despite this recent decline in the price of natural gas, it remains at elevated levels. BCA’s commodity and energy strategy team expects its volatility to stay high over the remaining winter months. First, Asia is not sitting on its hands as LNG shipments shift toward Europe. Instead, a bidding war is starting in order to attract liquefied gas to the East. Second, Europe’s winter is far from over, which means that demand-boosting cold fronts are still likely. Finally, Russia is sending gas back to its territory to fulfil its own domestic needs (and probably to continue to put pressure on European nations). Chart 6European Electricity Is Dear The continuation of elevated European natural gas prices and the potential for further upsides of volatility remain headwinds to European economic activity this winter, ones we deem comparable to Omicron. The main impact is via electricity prices. As Chart 6 highlights, they are still extremely high in France, Germany, and Spain. The continued surge in the price of CO2 emission quotas is increasing the pressure on electricity prices, as will the upcoming maintenance of many nuclear power plants in France. Gas consumption is contracting on a year-on-year basis in major European markets (Chart 7). This development indicates that elevated natural gas prices are already creating a supply shock to activity and sapping discretionary disposable income from households. The recent decline in European consumer confidence, despite strong employment numbers and growing net worth, confirms that households are feeling the pinch from elevated electricity and natural gas prices (Chart 8). Chart 8Consumers Feel The Pinch Chart 7Gap Consumption Is Slowing High natural gas and electricity prices also create further inflation risks for Europe. The recent spikes to 23.7% in PPI inflation and to 5% for headline CPI inflation show the effect of high-energy costs. Instead, a genuine threat would emerge if household inflation expectations followed energy prices, which could in turn trigger a wage-price spiral in Europe. We are not there yet, but the longer natural gas and electricity prices rise, the greater the likelihood of this scenario. Investment Implications The principal consequence of the strength of the European natural gas market is its euro-bearish impact. The tax on European growth is high, which delays the willingness of the ECB to remove monetary accommodation in a meaningful way. On the western shore of the Atlantic, the Fed is poised to pull the trigger soon and is now discussing a decrease in the size of its balance sheet, something the ECB is nowhere near ready to do. Consequently, although EUR/USD may be cheap and oversold on a cyclical basis, a turnaround is unlikely as long as electricity prices remain this elevated. Chart 9EUR/USD near An Existential Level Bottom Line: European natural gas prices may have come off their Christmas boil, but they remain elevated and will likely experience major bouts of upside volatility over the remainder of the winter. Hence, the drag on growth stemming from demanding electricity prices remains intact, which negatively affects consumer confidence. The euro cannot rally meaningfully until natural gas prices mean-revert, especially as the Fed ramps up its hawkishness. A re-test of EUR/USD long-term trendline around 1.10 is likely before the end of Q1 (Chart 9). The Evolution Of European PMIs European manufacturing activity remains below its June peak, but it has surprised many observers by how well it is withstanding the various shocks hitting the continent. Despite this encouraging behavior, it may take a few more months before the PMIs find a floor. The following three factors best explain why European manufacturing activity will decelerate further: The Chinese economic slowdown is not over. Credit growth is improving, but much of this comes from increasing purchases of banker’s acceptances by financial institutions, which does not in turn provide credit to the economy. Thus, European exports to China and EM will remain on the backfoot. The Omicron crisis remains intact and natural gas remains a drag, as previously discussed. Chart 10Manufacturing Deceleration Will End In Q2 The evolution of the Sentix Global Investor Survey and the ZEW survey, which are a very reliable forecaster of the Manufacturing PMI, points to more economic weakness in Q1 2022 (Chart 10). While these forces will hurt growth in the near term, they also suggest that this deceleration is long in the tooth and that activity will firm anew during the second quarter of the year. The gap between the expectation and current activity components of the Sentix Global Index Survey and the ZEW survey have already bottomed. Moreover, both Omicron and natural gas crises will ebb as winter passes. Finally, Chinese authorities will not let growth collapse and will likely generate a small pickup in activity after the Chinese New Year. Already, the PBoC has ramped up its liquidity injections and Premier Li Keqiang recently highlighted potential tax cuts and support for the corporate sector to help Q1 and Q2 domestic activity. Looking at European countries individually shows that current economic conditions are disparate and largely reflect the different impacts of both Omicron and natural gas prices. To judge economic conditions, we expand the Rotation Methodology introduced two months ago.1 Instead of analyzing financial assets, we examine manufacturing PMIs through this lens, looking at the evolution of the level and momentum of each country’s manufacturing PMIs compared to the overall European level. This approach reveals the following over the past six months (Chart 11): France experienced the greatest relative improvement, moving from a Lagging economy to the Leading economy in Europe. France benefits from limited lockdowns, from the large role of nuclear power in electricity generation, and from its diminished exposure to China’s slowdown compared to Germany. This economic performance explains why French equities have recently performed so much better than sectoral biases would have justified. The UK economy remains in the Leading quadrant despite the ferocity with which the Omicron wave has overtaken the nation. This paradox reflects the health policy chosen by Downing Street, emphasizing voluntary isolation and investing heavily in booster shots. Relative to that of the rest of Europe, Italy’s and Spain’s PMIs are still elevated, but they are losing momentum, which is pulling these two countries into the Weakening quadrant. The Netherlands suffered the greatest decrease in activity, dropping from the Leading quadrant to the Lagging one. The Netherlands is under a severe lockdown to combat the Delta wave. The situation is unlikely to improve meaningfully any time soon as the Omicron wave is starting there. Germany is trying to stage a recovery, moving from the Lagging quadrant into the Improving one. However, we worry that this will not work out and that Germany will shift back into the Lagging quadrant as the government prepares to crackdown further on COVID because the Omicron variant is starting to hit the country. Investment Implications Chart 12Peripheral Spreads To Stay Contained The continuation of the weakness observed in Germany and the Netherlands will force the ECB to remain more dovish than implied by the inflation rate. As a result, Spanish and Italian bond spreads are unlikely to move anywhere close to the levels recorded in the spring of 2020 (Chart 12), especially as their respective economies outperform those of Germany and the Netherlands.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Footnotes 1     The “Leading” (“Lagging”) quadrant denotes countries with PMIs performing better (worse) than the benchmark, the European manufacturing PMI, with strengthening (weakening) momentum. The “Improving” (“Weakening”) quadrant denotes countries with PMIs that are performing worse (better) than the benchmark, with strengthening (weakening) momentum. Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation 

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022​​​​​ Chart 2Strong Fundamental Support For US Growth​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability​​​​​​ In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022​​​​​​ When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 31Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades 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

Special Report

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 11th with our Portfolio Allocation Summary for January 2022. Highlights Interest Rate Policy: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. The Flexible Average Inflation Target: The re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. It is likely here to stay. The Long-Run Neutral Rate: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed. A Year Of Tightening The Fed started 2021 with three conditions for lifting rates (Table 1). Now, as we head into 2022, the Fed has officially acknowledged that the two conditions related to inflation have been met, and Fed Chair Jay Powell said that the economy is making “rapid progress” toward the final condition of “maximum employment”. Table 1The Fed's Liftoff Criteria Based on this, it looks like rate hikes are imminent. The Fed recently doubled its pace of asset purchase tapering so that net purchases will reach zero by mid-March. This opens up the March 2022 FOMC meeting as the first “live meeting” where a rate hike could occur. Our base case expectation is that the Fed will wait a tad longer, but that liftoff will occur at the June FOMC meeting. Rate hikes will then proceed through the end of the year at a pace of 25 basis points per quarter. Next, we discuss why the Fed has adopted this hawkish posture. We also consider the factors that would cause tightening to proceed more quickly or more slowly in 2022. Reasons For The Fed’s Hawkish Pivot Chart 1Labor Market Indicators It might sound odd to say that the US economy is rapidly approaching maximum employment. After all, the labor market is still 3.9 million jobs short of where it was in February 2020 (Chart 1). What’s more, only 59.2% of the population is employed today compared to 61.1% prior to the pandemic (Chart 1, panel 2). But Fed Chair Powell wasn’t referring to either of those figures when he said that the economy is making “rapid progress” toward maximum employment. Rather, he was referring to the unemployment rate, which currently sits at 4.2% (Chart 1, panel 3). This is only 0.2% above the Fed’s estimate of the natural rate of unemployment and only 0.7% above the pre-pandemic level of 3.5%. The fact that the unemployment rate has declined sharply means that the bulk of the shortfall in the economy-wide number of jobs is the result of people dropping out of the labor force (Chart 1, bottom panel), not the result of an increase in the percentage of the labor force that is unemployed. As recently as the November FOMC meeting, the Fed wasn’t drawing a sharp distinction between these two trends. In fact, Chair Powell said in his post-meeting press conference that “there is still ground to cover to reach maximum employment, both in terms of employment and in terms of participation.” But just one month later, at the December FOMC press conference, Chair Powell struck a much different tone. He said: Chart 2Participation Trends The Demographic Downtrend In Participation But the reality is, we don’t have a strong labor force participation recovery yet and we may not have it for some time. At the same time, we have to make policy now. And inflation is well above target. So this is something we need to take into account. It appears that the Fed is no longer confident that labor force participation is about to rise. There are a few good reasons for this. First, the aging of the US population imparts a structural demographic downtrend to the labor force participation rate as an increasing number of people reach retirement age (Chart 2). In addition, there was a sharp drop in 55+ participation at the onset of the pandemic that has so far not recovered at all (Chart 2, panel 2). It is debatable whether people in this older age cohort will ever return to work. Finally, there is a shortfall in participation for people in their prime working years (ages 25-54) (Chart 2, bottom panel). These people are likely not working because of factors related to the pandemic (e.g. fear of getting sick, caregiving requirements). It is likely that prime-age participation will rise as pandemic concerns fade, but the Fed is no longer confident that these pandemic concerns will fade quickly. Faced with elevated inflation right now, the Fed has decided that it must act against inflation earlier than it had intended, before prime-age labor force participation makes a full recovery. For bond investors, the important takeaway from the recent shift in Fed policy is that a recovery in labor force participation is no longer a pre-condition for liftoff. That being the case, we are very close to the Fed pulling the trigger on rate hikes. Table 2 shows the average monthly nonfarm payroll growth required to reach different target unemployment rates by different future dates, assuming the labor force participation rate remains at its current level. With the participation rate held flat, it only takes average monthly nonfarm payroll growth of 224 thousand to reach the pre-COVID unemployment rate of 3.5% by June. That same rate of growth would cause the unemployment rate to fall below the Fed’s 4% natural rate estimate by January. Table 2Average Monthly Nonfarm Payroll Growth (Thousands) Required To Reach Unemployment Rate Target By Given Date The message is clear. With rising participation no longer a pre-condition for hikes, the Fed’s “maximum employment” liftoff condition will be met within the next few months. We expect this will lead to the first Fed rate hike at the June 2022 FOMC meeting. What Happened To “Transitory” Inflation? Chart 3Core CPI Components The Fed’s view of the labor force participation rate is very similar to its view of inflation. Both are being influenced by the pandemic, but the Fed is no longer confident that pandemic concerns will fade in a timely manner. Looking at the inflation picture, it’s easy to see the impact of the pandemic. Core goods inflation is running at a year-over-year rate of 9.4%. It was close to 0% prior to COVID (Chart 3). This is obviously the result of pandemic-related supply chain disruptions and the shift in consumer spending away from services and toward goods. Just like with labor force participation, these trends should reverse as pandemic concerns fade. However, given the pandemic’s uncertain duration, the Fed is no longer willing to wait for that to happen. The Fed’s Interest Rate Projections In line with its hawkish shift on the definition of “maximum employment”, FOMC participants revised up their interest rate projections at the December meeting. The median FOMC participant is now looking for three 25 basis point rate hikes in 2022. This is consistent with liftoff in June followed by a pace of one rate hike per quarter (Chart 4). Interestingly, the market is reasonably well priced for this near-term path for rates. The deviation between market pricing and Fed expectations occurs further out the curve. As such, we recommend that US bond investors keep portfolio duration low and favor the 2-year Treasury note over the 10-year.1 Chart 4Rate Expectations What Would Make The Fed Go Faster? Chart 5No Wage/Price Spiral Yet As noted above, our base case forecast is that the Fed will start lifting rates in June 2022 and continue to hike at a pace of 25 bps per quarter. This is roughly consistent with the Fed’s own median projections. However, we acknowledge that the Fed will tighten policy more quickly if it sees evidence of an emerging wage-price spiral. Specifically, the Fed has pointed to the risk that real wage growth might exceed the rate of productivity growth. If that were to occur, the Fed would be worried about a wage-price spiral where firms lift prices to meet wage demands, but that only causes employee inflation expectations to rise further, leading to even greater wage demands. So far, this is not occurring. Real wage growth is negative and long-dated inflation expectations remain well-anchored near the Fed’s target levels (Chart 5). An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations during the next few months would cause the Fed to bring forward the liftoff date and increase the pace of rate hikes in 2022. What Would Make The Fed Go Slower? The main thing that would cause the Fed to tighten more slowly in 2022 would be if its hawkish shift prompted a severe tightening in overall financial conditions. Chart 6 shows that the ends of Fed tightening cycles typically coincide with the Goldman Sachs Financial Conditions Index moving above 100. This tightening in financial conditions also typically precedes a slowdown in economic growth (Chart 6, panel 2). Chart 6Watch Financial Conditions And Treasury Slope As The Fed Tightens Financial conditions are incredibly easy at present. But it is conceivable that risky assets will sell-off on fears of Fed rate hikes, and a large enough sell-off would cause the Fed to pause. The slope of the Treasury curve could also be a useful indicator in this regard. The 2/10 slope is usually close to inversion when the Fed ends its rate hike cycles (Chart 6, panel 3). Bottom Line: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. US bond investors should position for this outcome by keeping portfolio duration low and by favoring the 2-year Treasury note over the 10-year. FAIT Accompli It’s been roughly one year since the Fed concluded its Strategic Review and released a revised Statement on Longer-Run Goals and Monetary Policy Strategy.2 One year on, it seems appropriate to consider how much Fed policy actually changed as a result. We focus on what, in our view, are the two most significant changes to the Fed’s Statement. 1.  No More Pre-Mature Tightening First, the Fed changed its strategy to focus on “shortfalls of employment from its maximum level” rather than “deviations from its maximum level”. In the Fed’s words, “this change signals that high employment, in the absence of unwanted increases in inflation […], will not by itself be a cause for policy concern.” In the past, the Fed would tighten policy in response to a low unemployment rate on the expectation that inflation was about to increase. The new strategy is to wait for inflation to emerge before tightening, even if the unemployment rate is very low. Inflation has obviously emerged, so policy tightening is justified even under the new framework. Nonetheless, the evidence shows that the Fed has waited longer than usual to tighten. Chart 7A shows the change in the unemployment rate since the previous trough for the current cycle alongside the previous three cycles. For prior cycles, the lines end when the Fed delivers its first rate hike. While it’s notable that the unemployment rate has improved much more quickly this time around, it’s just as notable that the Fed still hasn’t lifted rates. This is despite the fact that the unemployment rate is only 0.7% above its pre-recession trough. This is more progress than was made before tightening in the 1990 and 2000 cycles, and about the same amount of progress as was made in the 107 months since the unemployment rate troughed before the Great Financial Crisis. A broader measure of labor market utilization, the prime-age (25-54) employment-to-population ratio, tells a similar story (Chart 7B). By this metric, the labor market has already made more progress than it did during the prior two cycles and the Fed still hasn’t increased the funds rate. All in all, even though inflation has emerged earlier this cycle than most expected, it’s pretty clear that the Fed’s new focus on employment “shortfalls” instead of “deviations” has made it act more dovishly. 2. Flexible Average Inflation Targeting (FAIT) The second big change that the Fed made to its Statement on Longer-Run Goals and Monetary Policy Strategy was the introduction of a Flexible Average Inflation Target (FAIT). Under the FAIT framework, the Fed will no longer view its 2% inflation target as purely forward looking. Rather, the Fed will seek to achieve average 2% inflation over time. This means that, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” While the Fed doesn’t specify a period over which it seeks 2% average inflation, it seems clear that the new inflation target has been achieved. PCE inflation is well above where it would have been if it averaged 2% since the new framework was adopted in August 2020 (Chart 8). This is also true if we pick February 2020, the peak of the last cycle, as our starting point. In fact, PCE inflation has almost made up for the entire inflation shortfall since January 2010. Chart 8The FAIT Framework While it’s interesting to look at average inflation over different lookback periods, it’s more important to note that the actual goal of the FAIT framework is to keep long-dated inflation expectations anchored near target levels. In the Fed’s own words: By seeking inflation that averages 2 percent over time this will help ensure that longer-run inflation expectations do not drift down and remain well anchored at 2 percent.3 If we judge the effectiveness of FAIT based on trends in long-term inflation expectations, then the only reasonable conclusion is that it has been a massive success. By any measure, long-term inflation expectations were well below levels consistent with the Fed’s 2% target in fall 2020. Now, they are very close to target levels. This is true whether we look at market-based measures (Chart 9A), survey measures (Chart 9B), trend measures (Chart 9C) or a composite indicator of many different measures (Chart 9D). Chart 9AMarket-Based Inflation Expectations Chart 9BSurvey-Based Inflation Expectations Chart 9CTrend Measures Of Inflation ##br##Expectations Chart 9DThe CIE Index The Fed's New Index Of Common Inflation Expectations (CIE) The Verdict All told, it looks like the Fed has made good on its promises. It refrained from lifting rates as the unemployment rate fell and has only now moved toward tightening in response to extremely high inflation. Also, the re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. Neutral Rate Expectations In 2022 Chart 10Neutral Rate Estimates There is one key issue for both Fed policy and bond markets that we have not yet discussed, and that’s the long-run neutral fed funds rate. This is the interest rate that, on average, will be consistent with the Fed’s price stability and maximum employment goals in the long run. As of today, the consensus among central bankers and investors is that the neutral rate is very low compared to history. There is also a widespread belief that it will remain low for the foreseeable future. For example, here is a sentence from the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy: The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. The top panel of Chart 10 shows that the Fed has revised its median estimate of the long-run neutral rate substantially lower since 2012, down from 4.3% to 2.5%. And it’s not just the Fed that has done so. The same downward revisions are seen in the Surveys of Market Participants and Primary Dealers (Chart 10, bottom 2 panels). Incidentally, the 5-year/5-year forward Treasury yield – a market-derived proxy for the long-run neutral rate – is below even the survey estimates. This is a key reason for our below-benchmark portfolio duration stance. Why Does The Fed Believe That The Neutral Rate Is Low And Will Stay Low? Chart 11The Demographic Effect New York Fed President John Williams has cited three key reasons for the low neutral fed funds rate: demographics, lower productivity growth and a heightened demand for safe and liquid assets.4 Of those factors, Fed research has determined that demographics are particularly important. The trend of increasing life expectancy, specifically, has been shown to be an important factor pushing interest rates down as people increase their savings in anticipation of a longer retirement (Chart 11).5 Could The Fed Be Wrong? We aren’t as confident that the neutral rate will stay low. In fact, we think it’s possible that both Fed and investor estimates understate the current long-run neutral rate. Our own Bank Credit Analyst has observed that the 5-year/5-year forward Treasury yield was very close to trend nominal GDP growth up until the 2008 financial crisis (Chart 12). Then, it dipped below as a protracted period of household deleveraging caused private sector credit demand to dry up. With household balance sheets no longer in disrepair, we are starting to see an increase in household debt, one that could eventually push bond yields back toward trend growth.6 It’s not just our own research that is starting to question the popular narrative of a low neutral fed funds rate. At the most recent Jackson Hole summit, Atif Mian, Ludwig Straub and Amir Sufi presented a paper that shows that rising income inequality is predominantly responsible for today’s low neutral rate (Chart 13), not the demographic effect previously identified by the Fed.7 Chart 13Rising Income Inequality ##br##Since 1980 Chart 12Household Deleveraging Kept Rates Low Post-2008 This research has important implications for the future evolution of the neutral rate. Unlike demographics, income inequality can be altered by changes in tax policy and by shifts in the power struggle between capital owners and workers. In this regard, our US Investment Strategy service has written several reports demonstrating the ongoing structural shift toward greater labor power.8 If this structural trend continues, it suggests that the long-run neutral rate may also rise. Trading The Neutral Rate While we suspect that the long-run neutral fed funds rate will turn out to be higher than both the market and Fed anticipate, we don’t think it’s wise to trade on that view in 2022. The reason is that expectations of a low neutral fed funds rate are extremely well-entrenched. It will take a lot of contrary evidence to shift those expectations, evidence we probably won’t get next year. As noted above, survey estimates of the long-run neutral rate range roughly from 2.0% to 2.5%. Our sense is that those estimates will only be revised higher if the fed funds rate gets much closer to those levels, say at least above 1%, and the economic data suggest that further rate increases will be required. This is a story for 2023, not 2022. A recent paper documented some interesting facts about the relationship between monetary policy and market expectations.9  It observed that the entire decline in the 10-year Treasury yield since 1990 has occurred during 3-day windows around FOMC meetings (Chart 14). This is not what we would expect to see if the long-run neutral rate was determined by independent macroeconomic factors that are distinct from Fed interest rate decisions. Chart 14Fed Rate Decisions Drive Long-Maturity Bond Yields We find this research very compelling. It suggests that the market changes its neutral rate expectations in response to Fed interest rate moves. In our view, this strengthens our conviction that a series of rate hikes will eventually cause the market to push its neutral rate expectations higher, leading to a sell-off in long-maturity bonds. Bottom Line: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For our full set of recommendations please see US Bond Strategy Special Report, “Key Views 2022: US Fixed Income”, dated December 14, 2021. 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-qas.htm#7 4 https://www.newyorkfed.org/newsevents/speeches/2018/wil181130#footnote3 5 https://www.frbsf.org/economic-research/files/el2017-27.pdf 6 For more details on this argument please see Bank Credit Analyst Special Report, “R-star, And The Structural Risk To Stocks”, dated March 31, 2021. 7 https://www.kansascityfed.org/documents/8337/JH_paper_Sufi_3.pdf 8 Please see January 13, January 20 and February 3, 2020 US Investment Strategy Special Reports, “An Investor’s Guide To US Labor History”, “Where Strikes Come From And Who Wins Them” and “The Public-Approval Contest”. 9 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3550593 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns