Fixed Income

Special Report

Highlights Barring major surprises, President Macron will be re-elected in 2022. Any dramatic reversal in the pandemic that leads to a new recession would benefit the opposition candidate. Otherwise, Macron will remain the frontrunner. A second term for President Macron would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. This is bullish for France. Reducing the size of the state will go a long way to improve France’s economic competitiveness over the long run. Tactically, favor the more defensive Spanish market over the highly cyclical French market. Underweight French consumer discretionary equities relative to their European and global peers. Longer term, overweight French industrials equities relative to German ones, and overweight French tech equities relative to European ones. Ahead of the election, buy the dip on any euro weakness and French OAT/German bund spread widening. Feature The French presidential election is nine months away, and it is already starting to catch investors’ attention as one of the main political events in Europe in 2022. In talks with clients, we’ve been asked repeatedly about the odds we assign to a Marine Le Pen victory and the market implications. Those concerns are understandable but overrated. Le Pen’s personal approval rating is on the rise, and, in most polls, the far-right candidate beats President Emmanuel Macron in the first round vote, although not the critical second round. Although the same polls see Macron being re-elected, the gap between the two has narrowed considerably since the 2017 election, which Macron won by 66 percent of the vote.   Still, Macron is favored for re-election. He has several strong advantages over Le Pen, and it is unlikely she will be able to close the gap further before the election. Macron’s first term has been eventful. Neoliberal structural reforms started with drums beating in the first 18 months of his term. But the pace and breadth of reform eventually became too ambitious or painful for France to bear, and protests erupted in 2018. First came the “Yellow Vest Movement,” and then came protests against pension reform. Macron tried to compromise and continue with his agenda, but COVID-19 forced his hand. Since then, Macron has focused on crisis management, benefiting from the large state sector’s role as an automatic stabilizer amid the downturn. A second term under President Macron would see a reboot of the structural reforms started in 2017, albeit without single-party rule in the National Assembly. Reforms aimed at reducing the size of the state, and its cost, would go a long way to improve France’s economic competitiveness over the long run. Therefore, the prospect of Macron’s reelection is bullish for France, even though the reality of his second term would be more complex. 2017 All Over Again? Yes And No At first glance, the 2022 election seems to be a repeat of 2017. Le Pen and Macron are likely to face off in the second round and the latter, the Europhile centrist candidate, is likely to win once more. However, everything surrounding this election has changed. The Incumbency Effect One of the major changes is favorable for Macron: he is the incumbent running for re-election. Macron had been part of President Francois Hollande’s government since 2014, so he was still viewed in 2017 as a political neophyte and dark horse candidate. His rapid rise to power, along with that of his upstart party, La République En Marche (LREM), was astounding. Chart 1Pro-Incumbency Effect Favors Macron There is a strong pro-incumbency effect in French presidential elections, especially in the first round (Chart 1). Since 1965, five incumbents have run for re-election, and all have made it to the second round. Importantly, four won first place in the first round, with a six percentage-point margin on average. The chief exception is Nicolas Sarkozy in 2012. The reason for Sarkozy’s loss, however, is well known: he attempted to pass an unpopular pension reform in the teeth of the Euro debt crisis, 12 months before facing re-election. The only other incumbent who failed at re-election was Valerie Giscard d’Estaing, who lost to Francois Mitterrand in 1981, when the whole world was in stagflation and upheaval. The incumbency effect is not as pronounced in the second round (Chart 1, bottom panel). However, when facing a far-right candidate, incumbents win by a wide margin. This was the case in 2002 and 2017. Today, Macron still has a 12-point lead on Le Pen. Macron compares well to his predecessors. Chart 2 shows the approval rating for all presidents sitting in office over the past 40 years. The number of people who intend to vote for Macron has increased, the first time this has happened for an incumbent president since 1988. Only three presidents had a higher approval rating at this stage of their term, albeit from a higher starting point. Macron’s approval rating has increased by 10% since February 2020, when the COVID-19 pandemic hit Europe. Chart 2Macron Compares Well To His Predecessors Table 1Incumbency And Recessions Under The Fifth Republic The shock of the pandemic and recession is the greatest change since 2017, and the biggest challenge facing Macron. Four incumbents have made a bid for re-election that was preceded by a recession within 12-24 months (Table 1). The results are mixed, and it is hard to establish a clear anti-incumbency effect. If anything, the timing and nature of this crisis are likely to help Macron rather than hurt him, since the vaccination campaign and easing of lockdown measures will enable the economy to normalize and improve ahead of April 10-24, 2022, when voters cast their first ballots. Nonetheless, another major shock (of any kind) could undermine the incumbent advantage. Economic Recovery Is The Top Priority While the Macron administration’s handling of the pandemic was questioned, public opinion was never aggressively hostile toward his handling of the economy. Macron was instrumental in securing a major European fiscal stimulus package (and joint debt issuance) with the German Chancellor, Angela Merkel. He enthusiastically adopted the crisis mentality of “whatever it takes” to wage war against COVID-19, enabling the oversized French state to deploy the most generous furlough scheme in Europe, shielding millions of workers and preventing businesses from going under. This will be one of his winning cards. Chart 3The Handling Of The Pandemic Dictates Macron's Popularity His approval rating began to rebound following the end of lockdowns (Chart 3). This trend should strengthen as the French economy reopens, supported by a government that will play an accommodative and reflationary economic role until the election. Public opinion wants him to focus on the labor market and the economic recovery in the months to come, and he will be happy to oblige. Public opinion also views Macron as the most qualified candidate when it comes to economic matters (Table 2). 42% of respondents think that Le Pen is not qualified “at all” on economic matters, her Achilles’ heel, a perception that was already entrenched when Macron crushed her in a televised debate before the second round of the 2017 election. Table 2Macron Is Perceived As The Most Qualified To Oversee The Economic Recovery Europhile Versus Eurosceptic? The central issue of the 2017 election was Europe and France’s role in it. Following the UK’s disruptive Brexit referendum in 2016, and a long tradition of Euroscepticism within her party, Le Pen campaigned on “Frexit” and the abandonment of the euro. Conversely, Macron embraced the EU and the monetary union as he ran for president and committed to having France play a more important role within the bloc if he won. Chart 4Le Pen And The EU: Not The Divorce We Expected Since then, Le Pen has drastically shifted her stance on the EU. She now claims that the benefits of the common currency and single market outweigh the costs. After all, 70% of the French public support the euro and EU membership (Chart 4). Like clockwork, her personal approval ratings have steadily gone up. This strategic shift aligns her with the median voter, and combined with the Covid crisis, it is the only reason to take her candidacy remotely seriously in 2022, despite Macron’s clear advantages. Nevertheless, Le Pen has not yet risen above her 2012 peak in popular support. She failed to do so between 2014 and 2015, when the lingering European debt crisis, the Syrian refugee crisis, multiple terrorist attacks in France, and sluggish economic growth should have boosted her popularity. Her shifting perspective on the euro was therefore necessary and might be just what she needs to break through her 37% ceiling of popular support. Le Pen’s policy agenda is now focusing on protectionism, immigration, and national security. It is a Trumpian mix. However, while her new stance is more mainstream, it also differentiates her less from the other center-right politicians in France, namely Xavier Bertrand, who recently made local electoral gains in Le Pen’s northern industrial base. Macron is as strong an advocate for Europe as ever. He convinced Germany to break the taboo on joint fiscal policy during the pandemic. Now, he is also mounting a bid to become the natural leader of Europe, given that Merkel is stepping down, and her party is likely to lose standing in the German election in September.  France is set to take over the rotating EU Council Presidency in the first half of 2022, under the theme “Recovery, power, belonging,” which provides Macron with a golden opportunity to pitch himself as Europe’s premier statesman and economic steward in the final months of the election campaign. One Thing Hasn’t Changed: The Outcome Of A Macron/Le Pen Duel Most opinion polls give Macron a 10-12 point lead on Le Pen in the second round of the election. This gap is wide enough to reassure investors that it is not a polling error. However, in 2017, Macron’s average lead over Le Pen was 22%, and he won the election with 66% of votes. It is the narrowing of that gap that raises eyebrows among investors. Table 3Ideological Blocs Also Favor Macron Still, Le Pen’s chances at closing the gap are overrated. She is not a political “unknown” anymore and has very little ability to “surprise” voters into rallying around her next year. She will have trouble persuading those who know all about her. Grouping French voters according to ideological blocs, that is, presidential preference by party affiliation, suggests that the biggest threat to Macron is a strong center-right candidate who can beat Le Pen, especially if this should coincide with a revival of the center-left (Table 3). Otherwise, as in 2017, Macron will be able to count on voters from other parties in the second round of the election (Table 4). While both candidates appeal to right-wing constituents and would have to share their ballots, Macron can count on the green EELV party, as well as left-wing voters, to join center-right voters to elect him. Macron has made environmental issues a part of his mandate, which should help him confront a green neophyte such as Le Pen. Table 4Voting Against Le Pen Implies Voting For Macron The results of the regional elections held last month confirm this analysis. The motivation to keep Le Pen and her Rassemblement National (National Rally) party out of power is still strong (see Box 1). The poor showing of the National Rally means she won’t be able to maintain her current momentum in her personal approval ratings.   Box 1 2021 Regional Elections: Bad Omen For Marine Le Pen In Revival Of The Center-Right? The regional elections took place on June 20 and 27. While limited in relevance for the 2022 presidential race, the result of extremely low voter turnout, regional elections offer a gauge of how constituents feel about the political offerings from anti-establishment parties. Le Pen’s party suffered a heavy blow. It had hoped to consolidate power and build momentum ahead of the presidential election, but it failed even to win in its stronghold of Southern France. Meanwhile, Macron’s party (La République En Marche!) also disappointed. This outcome is not surprising; the local elections last year yielded similar results, highlighting the lack of presence at the local and regional levels for the four-year-old party. The surprise came from the center-right. It managed to win seven of the thirteen regions, beating far-right candidates by wide margins. Importantly, Xavier Bertand, Valérie Pécresse, and Laurent Wauquiez, all predicted to run for president next year, held onto their seats.   Chart 5Strong Demographic Base In The Second Round Both candidates’ demographic bases have remained the same. Macron is still popular among Millennials, white collar workers, and the elderly (Chart 5). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, and he still outperforms Le Pen among rural voters in today’s polls. Macron also scores high among the employees of the public sector—even though he is in favor of a smaller public sector. Furthermore, the unemployed mostly favor him, which reinforces the perception that he is the best candidate to improve the French economy and cut the unemployment rate. What if Le Pen fails to make it into the second round of the election? We discuss this possibility in the next section. Risks To The Base Case Scenario The greatest risks to our view are a setback in the economic recovery, an outperformance from the center-right, and the emergence of a dark horse. The latest developments in the UK and Israel, where a large share of the population is fully vaccinated, suggest that the “Delta” variant of COVID-19 remains a threat, with the potential to send economies back into lockdowns. The consequences would be dire for Macron. His chances at re-election would likely evaporate if his government imposed new lockdown measures. What about presidential candidates other than Le Pen? Our base case scenario that Macron will win is based on two assumptions: (1) the center-left Socialist Party will remain in shambles, and (2) the center-right remains scattered under different banners and will therefore lack unity. There is very little chance that the center-left will make a comeback in time, but the results from the regional elections suggest that the center-right could surprise to the upside (see Box 1), especially if it decides to rally behind a single candidate ahead of the first round. Could this candidate be a dark horse? Former Prime Minister Edouard Philippe or outsider candidate Xavier Bertrand could make formidable opponents to both Macron and Le Pen. Philippe’s personal approval rating currently stands at 50%, the highest among French politicians. He also appeals to constituents of all political leanings (Chart 6). This scenario could reshuffle the likely outcomes of both the first and second round of the election. Both Bertand and Philippe could win over voters who decided to side with Le Pen in 2017, while Philippe can compete with Macron over LREM voters. Additionally, Xavier Bertrand cuts into Le Pen’s support since he has made blue collar workers and the middle-class a priority. However, Macron and Le Pen each enjoy a strong voters’ base. It is necessary to monitor whether Valérie Pécresse (Soyons libres) and Laurent Wauquiez (Les Républicains) can be brought to endorse Xavier Bertrand ahead of the first round in 2022. Chart 6Edouard Philippe: From Ally To Outcast To Challenger? Beyond The Election Aside from the presidency, the outstanding question is the makeup of the National Assembly in 2022. Macron is not likely to enjoy the strong single-party legislative majority of his first term or to gain control of the Senate. Consequently, he will be more constrained in the legislature in a second term. Nonetheless, the demand for a better economy and a healthier job market requires pro-productivity reforms, which the public knows, and Macron has made reform his banner. Other conventional parties will come under pressure to support Macron’s reform agenda, even though that agenda will be less ambitious than it was in his first term. Chart 7Strong Presence Of Right-Leaning Forces Efforts at cutting back the size of the state are still likely, even though the pandemic has helped rather than hurt statism. This is because the French median voter, who never witnessed the degree of neoliberal reform that took place in the Anglo-Saxon world, has grown weary of the economy’s inefficiencies, just as the Anglo-Saxons have grown weary of laissez-faire neoliberalism. Before the pandemic, the French people understood the need to reduce the size of the state. After all, a larger state implies a larger cost burden borne by both households and corporations. When faced with the choice between paying the bill for the government’s fiscal response to COVID-19 (through higher taxes), or undertaking reforms aiming at reducing the size of the state, the French people will pick the former. Moreover, centrist forces will hold sway in the legislature (Chart 7); hence, some kind of budget normalization is expected in 2023 or thereafter. Other structural reforms If Macron wins would include pension reforms. We should also expect measures to push French companies to bring activities back to France, as well as a greater focus on leading France on the green path. Bottom Line: Barring major surprises, President Macron will be re-elected in 2022. There is a risk to our view if a center-right candidate defeats Le Pen to make it to the second round of the election. Either Macron or a center-right presidency would see a continuation of the structural reforms started in 2017, but with a longer process for coalition-building in the National Assembly. Investment Implications The French economy is currently experiencing an economic upswing. Three factors explain this pick-up: ultra-accommodative monetary conditions in Europe, fiscal largesse, and considerable pent-up demand. In 2021, GDP is projected to expand by 5.75% in annual average terms, higher than the Euro Area average of 4.6%. It should then grow by 4% in 2022 and by 2% in 2023. We remain bullish on French equities on a secular basis, as long as the elections result in further incremental structural reforms over time. As the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip. French Equities The CAC40 and French equities have had a good run since the beginning of the year. In absolute terms, the CAC40 is one of the best performers year-to-date, up +17%, driven by the outperformance of French consumer discretionary and financials equities, both in absolute and relative terms. However, a period of turbulence is appearing on the horizon; the shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries are creating headwinds for the cyclicals-to-defensives ratio this summer. As such, we recently recommended investors downgrade cyclical equities tactically in Europe from overweight to neutral. With 66% in cyclicals, the French MSCI equity index will underperform in this environment, especially relative to the more defensive Spanish market (Table 5). Table 5Cyclicals Versus Defensives In European Markets Chart 8Three Trade Ideas In fact, our Combined Mechanical Valuation Indicator (CMVI) shows that French consumer discretionary equities are expensive relative to both their European and global peers (Chart 8). Regarding the reform theme, we stick with our long French industrial equities / short German industrial equities on a long-term horizon (Chart 8, second and third panel). The idea is that French reforms should suppress unit labor costs and make French exports more competitive vis-à-vis their main competitor, Germany. The latter faces a leftward shift in policy in elections this September. Finally, we recommend investors go long French tech stocks relative to their European counterparts. This sector is cheap (Chart 8, bottom panel), and the French tech sector will be supported by additional government spending of EUR7 billion on digital investments over the next two years. Bond Markets & FX A dovish ECB is consistent with a continued overweight in European peripheral bonds and an underweight stance on French government bonds. Chart 9Just Buy The Dip What is more relevant with respect to the French election is the OAT/Bund spread. In the past, unusually wide spreads between the two represented a euro breakup premium. In early 2017, spreads widened when the approval rating of Le Pen increased (Chart 9). However, since “Frexit” and the abandonment of the euro are no longer part of Le Pen’s agenda, investors should view spread widening as a buying opportunity. Similarly, investors should buy the euro on any election-related dip, particularly following the first round. “Frexit” has been removed from the equation, hence the euro should not weaken on breakup risk this time around. Bottom Line: We remain bullish on French equities within a European portfolio on a secular basis. If our views on the cyclicals-to-defensives ratio materialize in the near-term, highly cyclical French equities will temporarily underperform, unlike the more defensive Spanish market. On a 3- to 12-month horizon, investors should short French consumer discretionary equities relative to both their European and global counterparts. Current valuations suggest that betting on the booming French tech sector at the expense of its European neighbors will be profitable. Once the election draws nearer, investors should treat any French OAT/German Bund spread widening as a buying opportunity and purchase the euro on any election-related dip.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com

Highlights The US dollar will reach its ultimate high in the next deflationary shock. The swing factor for dollar demand is portfolio flows. In the next shock, portfolio flows will surge into US investments, driving up the US dollar to its ultimate high. One reason is that the US T-bond is the only major bond that can act as a haven-asset, now that most other bond yields are close to the effective lower bound. For US investors, international stocks will create a double-jeopardy. Not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. For non-US investors, the US 30-year T-bond will create a double-win from price surge and dollar surge, leading to a potential doubling of your money. Fractal trade shortlist: stocks versus bonds, tin, and US REITS versus US utilities. Feature Chart of the WeekSuccessive Shocks Take The Dollar To New Highs In our recent report The Shock Theory Of Bond Yields we explained that the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that an economy has endured. Each successive deflationary shock takes the bond yield to a lower low. Until it can go no lower (Chart 2). Chart I-2Successive Shocks Take The T-Bond Yield To New Lows Today’s report explains an important corollary. Each major deflationary shock has taken the US dollar to a new high, led by strong rallies against cyclical currencies such as the pound and the Canadian dollar (Chart of the Week, Chart I-3 and Chart I-4). We conclude that the US dollar will reach its ultimate high in the next deflationary shock. Chart I-3USD/GBP Surges In Shocks Chart I-4USD/CAD Surges In Shocks   Investors Must Build Shocks Into Their Strategy Most strategists claim that shocks, such as the pandemic, are inherently unpredictable. They argue that shocks are exogenous events that investors cannot plan for. We disagree. Granted, the timing and source of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the likelihood of suffering a shock is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or to slump by at least 25 percent.1 Using this definition through the past five decades, shocks have arrived with a remarkable predictability (Chart I-5). As a statistical distribution, the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). Chart I-5A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years Hence, in any three-year period, the likelihood of suffering a shock is 50 percent; in a five-year period, it is 81 percent; and in a ten-year period, it is a near-certain 96 percent (Chart I-6). Chart I-6On A Multi-Year Horizon, A Shock Is A Near-Certainty Yet, to repeat, the precise source and timing of the near-certain shock is unknown. This creates a dissonance for our narrative-focused minds. Absent a narrative for the certain shock, we do not plan for it. But we should. For long-term investors one crucial takeaway is that the ultimate low in the T-bond yield is yet to come. Another crucial takeaway is that the ultimate high in the US dollar is also yet to come. In A Shock, The US Dollar Surges The net demand for dollars comes from four sources: To fund the demand for goods and services denominated in dollars. (In fact, the structural US deficit in goods and services means that this source generates a persistent supply of dollars.) To fund the demand for long-term investments denominated in dollars, also known as foreign direct investment (FDI). To fund the demand for shorter-term financial investments like bonds and equities denominated in dollars, also known as portfolio flows.2 To fund the demand for currency reserves denominated in dollars. Of these four sources of dollar demand, the US deficit in goods and services is not particularly volatile. FDI flows also change relatively slowly. Meanwhile, demand for dollar reserves is a residual factor, except at the rare moment that a currency peg starts or ends.3  The largest quarterly swings in portfolio flows swamp the largest quarterly swings in the trade balance and FDI. This means that the swing factor for dollar demand is portfolio flows. Chart I-7 and Chart I-8 show that the largest quarterly swings in portfolio flows, at over $1.5 trillion (annualised rate) swamp the largest quarterly swings in the trade balance and FDI, at just $0.5 trillion. Chart I-7The Swing Factor For Dollar Demand Is Portfolio Flows Chart I-8The Swing Factor For Dollar Demand Is Portfolio Flows All of which brings us to the main point of this report. In a shock, portfolio flows surge into US investments, which drives up the US dollar. In a shock, portfolio flows surge into US investments, which drives up the US dollar. There are two reasons for this. First, the US stock market is one of the most defensive in the world. Hence, in a shock, equity flows flood into the US (Chart I-9). Chart I-9The US Stock Market Is One Of The Most Defensive In The World But even more important now, the US T-bond is the only major bond that can act as a haven-asset. With most other bond yields already close to the effective lower bound, the US T-bond is the only mainstream asset which still has substantial scope to rally when other asset prices are collapsing. Hence, in recent years, the dollar is just tracking the performance of bonds versus stocks (Chart I-10). It follows that in the next deflationary shock, when bonds surge versus stocks, the dollar will surge to its ultimate high. Chart I-10The Dollar Is Just Tracking Bonds Versus Stocks An Inflationary Shock Will Quickly Morph Into A Deflationary Shock But what if the next shock is a dollar crisis? Such a crisis, caused by a loss of faith in the greenback as a store of value, would start off inflationary – to the detriment of the dollar. However, our high-conviction view is that even if the shock started as inflationary, it would quickly morph into deflationary. The simple reason is that the initial backup in bond yields that would come from such an inflationary shock would collapse the value of $500 trillion worth of global real estate, equities, and other risk-assets, and thereby unleash a massive deflationary impulse. Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. Investors demand a massive risk premium when inflation is out of control. The starting valuation needed to generate a given real return during an inflationary shock collapses because investors demand a massive risk premium when inflation is out of control. For example, in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But to generate the same real return of 10 percent during the inflationary 1970s, the starting multiple had to halve to 7 (Chart I-11). Chart I-11In An Inflationary Shock, Valuations Collapse Suffice to say, if the valuation of $500 trillion of global risk-assets were to halve, we would not have to worry about inflation. So, to sum up: On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise source or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a net deflationary shock or shocks into their long-term investment strategy. Specifically, in the next shock: US equities will outperform non-US equities. The 10-year T-bond yield will reach zero, and the 30-year T-bond yield will reach 0.5 percent. The US dollar will reach its ultimate high. This leads to two very important messages, one for US investors, one for non-US investors. For US investors, international stocks will create a double-jeopardy. In the next shock, not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. The corollary for non-US investors is that the US 30-year T-bond will create a double-win. Not only will the T-bond price surge, but the dollar will also reach a new high. The combination will lead to a potential doubling of your money. H1 2021 Win Ratio Reaches A Magnificent 71 Percent Last Thursday’s 16 percent rally in Nike shares on a brighter sales outlook means that our long Nike versus L’Oréal trade quickly achieved its 9 percent profit target. Long USD/HUF also quickly achieved its 3 percent profit target. Combined with other ‘wins’, this has boosted the fractal trades win ratio for H1 2021 to a magnificent 71 percent – comprising 12.1 wins versus just 4.9 losses. A fragile fractal structure is a warning that the investors setting the investment’s price has become dangerously biased to short-term traders. As longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. This creates an excellent countertrend investment opportunity because once the longer-term investors re-enter the price setting process, the recent trend will reverse. This week we highlight three fragile fractal structures. The fractal structure of stocks versus bonds (MSCI All Country World versus 30-year T-bond) remains fragile, suggesting that a neutral stance, at best, for stocks versus bonds through the summer (Chart I-12). Chart I-12The Fractal Structure Of Stocks Versus Bonds Is Fragile The fractal structure of tin is also fragile (Chart I-13). Given that most commodity prices have begun corrections, tin is vulnerable – especially versus other commodities. Chart I-13The Fractal Structure Of Tin Is Fragile Finally, comparing two high-yielding sectors, the fractal structure of US REITS versus US utilities is at a point of fragility that has reliably presaged countertrend moves (Chart I-14). Accordingly, this week’s recommended trade is to short US REITS versus US utilities, setting the profit target and symmetrical stop-loss at 5 percent. Chart I-14Short US REITS Versus US Utilities   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 In this discussion, portfolio flows include short-term speculative flows. 3For example, if a currency broke its peg with the dollar it would stop buying the dollar reserves needed to maintain the peg. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart I-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields - Asia Chart I-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth is peaking but will remain solidly above trend. While the proliferation of the Delta strain is likely to trigger another wave of Covid cases this summer, the economic impact will be far smaller than during past waves. Global Asset Allocation: The risk-reward profile for stocks has deteriorated since the start of the year. Nevertheless, with few signs that the global economy is heading towards another major downturn, investors should maintain a modest equity overweight on a 12-month horizon. Equities: Favor cyclicals, value-oriented, and non-US equities. Emerging markets should spring back to life in the autumn once vaccine supplies increase and Chinese fiscal policy turns more stimulative. Fixed Income: Maintain below average interest-rate duration exposure. The 10-year US Treasury yield will finish the year at 1.9%. Spread product will continue to outperform high quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. EUR/USD will finish the year at 1.25. Commodities: Brent will rise to $79/bbl by end-2021, 9% above current market expectations. While the lagged effects from the slowdown in Chinese credit growth earlier this year will weigh on base metals during the summer months, the long-term outlook for metals is positive. Favor gold over cryptos as an inflation hedge. I. Macroeconomic Outlook Global Vaccination Campaign Kicks Into High Gear Nearly 18 months after the pandemic began, the global economy is on the mend. In its latest round of forecasts released on May 31st, the OECD projects that the global economy will expand by 5.8% this year, up from its March projection of 5.6%. The OECD also bumped up its growth forecast for 2022 from 4% to 4.4%. After a rough start, the vaccination campaign is progressing well in most advanced economies (Chart 1). The US and the UK were the first major developed economies to roll out the vaccines, followed by Canada and the EU. While Japan has lagged behind, the pace of vaccinations has picked up lately. Twenty percent of the Japanese population has now received at least one dose. Developing economies are still struggling to secure enough vaccines. Fortunately, this problem should abate over the next six months. The Global Health Innovation Center at Duke University estimates that pharmaceutical companies are on track to produce more than 10 billion vaccine doses this year (Chart 2). While perhaps not enough to inoculate everyone who wants a jab, it will suffice in providing protection to the most vulnerable members of society – the elderly and those with pre-existing medical conditions. Chart 1The Vaccination Campaign Is Progressing Well In Most Developed Economies Chart 2Vaccine Makers Are On Track To Produce Over 10 Billion Doses In 2021 New Variants And Vaccine Hesitancy Are Risks Novel strains of the virus remain a concern. First identified in India, the so-called “Delta variant” is spreading around the world. The number of new cases in the UK, where the Delta variant accounts for over 90% of all new infections, is rising again (Chart 3). The latest outbreak has forced the government to postpone “Freedom Day” from June 21st to July 19th (Chart 4). Chart 3The Number Of New Cases In The UK Is Rising Anew Chart 4Dismantling Of Lockdown Measures Occurring At Varying Pace     It is highly likely that the Delta variant will produce another wave of cases in the US this summer. Despite ample availability, one-third of Americans over the age of 18 have yet to receive a single dose of a vaccine. As is the case with most everything in the United States, the question of whether to be inoculated has become politicized. In many Republican-leaning states, more than half the population remains unvaccinated (Chart 5). Chart 5The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants Vaccine hesitancy will likely diminish as the evidence of their effectiveness continues to mount. According to analysis by the Associated Press using CDC data, fully vaccinated people accounted for less than 1% of the 18,000 COVID-19 deaths in the US in May. A study out of the UK showed that two doses of the Pfizer-BioNTech vaccine was 96% effective against hospitalization from the Delta variant, while the Oxford-AstraZeneca vaccine was 92% effective. While another wave of the pandemic will curb growth this summer, the economic impact will be far smaller than in the past. At this point, the initial terror of the pandemic has faded. Politically, it will be more difficult to justify lockdowns in countries such as the US where almost everyone who wants a vaccine has already been able to get one. Macro Policy Outlook: Tighter But Not Tight After cranking the fire hose to full blast during the pandemic, policymakers are looking to scale back support. On the fiscal side, governments are slowly starting to rein in budget deficits. The IMF expects the fiscal impulse in advanced economies to average -4% of GDP in 2022, implying an incrementally tighter fiscal stance (Chart 6). Chart 6Budget Deficits Set To Decline, But Remain High By Historic Standards Tighter does not necessarily mean tight, however. The IMF sees advanced economies running an average cyclically-adjusted primary budget deficit of 2.6% of GDP between 2022 and 2026, compared to an average deficit of 1.1% of GDP between 2014 and 2019. In the US, Congress is debating an infrastructure bill, a key element of President Biden’s “Build Back Better” agenda. If the bill fails to move out of the Senate, our geopolitical strategists expect Congress to use the reconciliation process to pass most of Biden’s legislative program. This should result in an additional 1.3% of GDP in federal spending per year over the next 8 years, offset only partly by higher taxes. Chart 7EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 8Japanese PMIs Stuck In The Mud In the euro area, the IMF expects fiscal policy to remain structurally looser by nearly 2% of GDP in the post-pandemic period. After six months of parliamentary debates, all 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 7). Most of the money will be spent on public investment projects with high fiscal multipliers. Japan has a habit of tightening fiscal policy at exactly the wrong moment, with the October 2019 hike in the sales tax from 8% to 10% being no exception. Unlike in other developed economies, both the Japanese manufacturing and services PMI remain stuck in the mud (Chart 8). The odds are rising that Prime Minister Yoshihide Suga will announce a major stimulus package after the Olympic Games and ahead of the general election due by October 22nd. China: Normalization Not Deleveraging Chart 9China: Weak Infrastructure Spending Should Pick Up In China, strong export growth, propelled by the shift in global spending towards manufactured goods during the pandemic, allowed the government to tighten fiscal policy modestly in the first half of the year. Looking out, fiscal policy should turn more stimulative. Local governments used only 16% of their bond issuance allocation between January and May, compared with 59% over the same period last year and 40% in 2019. Proceeds should benefit infrastructure spending, which has been on the weak side in recent years (Chart 9). After a sharp decline, Chinese credit growth should stabilize in the second half of the year. The current pace of credit growth of 11% is near its 2018 lows and is broadly in line with nominal GDP growth (Chart 10). Given that the authorities have stated their desire to stabilize the ratio of credit-to-GDP, they are unlikely to proactively suppress credit growth further. The recent decline in the 3-month SHIBOR, which usually moves in the opposite direction of credit growth, is evidence to this effect (Chart 11). Chart 10Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chart 11China: Easing Off The Brakes? Nevertheless, changes in fiscal and credit policy tend to affect the Chinese economy with a lag (Chart 12). Thus, the tightening in fiscal policy and the deceleration in credit growth that occurred early this year could still weigh on economic activity during the summer months. Chart 12China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag Don’t Sweat The Dot Plot Markets interpreted the June FOMC meeting in a hawkish light. Both the 2-year and 5-year yield jumped 10 basis points following the meeting (Table 1). The US dollar, which is quite sensitive to changes in short-term rate expectations, strengthened by nearly 2%. In contrast, long-term bond yields declined following the meeting, with the 10-year and 30-year bond yield falling by 6 and 19 basis points, respectively. Table 1Change In Yields Following June FOMC Meeting As long duration assets, stocks take their cues more from long-term yields than short-term rates. Hence, it was not surprising that equities held their ground, and that growth stocks reversed some of their underperformance against value stocks this year. Chart 13Markets Interpreted The June FOMC Meeting In A Hawkish Light This publication agrees with BCA’s bond strategists that the market overreacted to the changes in the Fed’s projections (aka “the dots”). As Chair Powell himself noted during the press conference, the dot plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” The market is currently pricing in 105 basis points of tightening by the end of 2023. Prior to the meeting, investors were expecting 85 basis points in rate hikes (Chart 13). The regional Fed presidents tend to be more hawkish than the Board of Governors. Our guess is that Jay Powell himself only penciled in one hike for 2023. Lael Brainard, who may be replacing Powell next year, likely projects no hikes for 2023. The Path To Full Employment Chart 14The Divergence Of Goods And Services Spending Rather than obsessing over the dots, investors should focus on the questions that will actually drive Fed policy, namely how long it takes the US economy to return to full employment and what happens to inflation in the interim and beyond. There is a lot of uncertainty over these questions – both on the demand side (how fast will spending recover?) and the supply side (how much labor market slack is there and how quickly can firms ramp up hiring?). On the demand side, the pandemic led to unprecedented changes in household spending and saving behavior. As Chart 14 shows, goods spending surged while services spending collapsed. Overall spending declined, and together with increased transfer payments, savings ballooned. As of May, US households were sitting on $2.5 trillion in excess savings. Looking at disaggregated bank deposit data as a proxy for the distribution of household savings, the wealthiest 10% of households accounted for about 70% of the increase in savings between Q1 of 2020 and Q1 of 2021 (Chart 15). Given that richer households have relatively low marginal propensities to spend, this suggests that a large fraction of these excess savings will remain unspent. Nevertheless, $2.5 trillion is a lot of money – it’s equal to almost 17% of annual consumption. Hence, even if a third of this cash hoard were to make its way into the economy, it could buoy aggregate demand significantly. Chart 15Excess Savings Have Mostly Flowed To The Rich A Labor Market Puzzle Turning to the supply side, there were over 4% fewer people employed in the US in May than in January 2020 (Chart 16). On the face of it, this would suggest the presence of a significant amount of labor market slack. Chart 16US Employment Still More Than 4% Below Pre-Pandemic Levels Yet, the NFIB small business survey tells a different story. It revealed that 48% of firms reported difficulty in filling vacant positions in May, the highest percentage of respondents in the 46-year history of the survey (Chart 17). Chart 17US Labor Market Shortages (I) Chart 18US Labor Market Shortages (II)   Along the same lines, the nationwide job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The quits rate, a good proxy for worker confidence, is also at a record high (Chart 18). How does one reconcile the low level of employment with other data pointing to a tight labor market? As we discussed in a report two weeks ago, four explanations stand out: Generous unemployment benefits, which have depressed labor force participation among low-wage workers (Chart 19). Chart 19Labor Scarcity Prevalent In Low-Wage Sectors Chart 20School Closures Have Curbed Labor Supply Pandemic-related school closures. As Chart 20 shows, they have had a noticeable impact on labor force participation among women with young children. Reduced immigration. At one point during the pandemic, visa issuance was down 99% from pre-pandemic levels (Chart 21). An increase in early retirements. We estimate that about 1.5 million more workers retired during the pandemic than would have been expected based solely on demographic trends (Chart 22). Chart 21US Migrant Worker Supply Is Depressed Chart 22The Pandemic Accelerated Early Retirement All but the last effect is likely to be fleeting. Enhanced unemployment benefits expire in September; President Biden has reversed President Trump’s ban on most worker visas; and schools should fully reopen by the fall. And even for the retirement effect, most recent retirees were approaching retirement age anyway. Thus, there will likely be fewer incremental retirements over the next few years. A Speed Limit To Hiring? Assuming that a large fraction of sidelined workers return to the labor market in the fall, how fast will firms be able to hire them? In general, we are skeptical of arguments claiming that there is much of a speed limit to the pace of hiring. Chart 23There Is A Lot Of Churn In The Labor Market There is a lot of churn in the labor market. Gross job flows are much larger than net flows. Between 2015 and 2019, 66.1 million people were hired on average per year compared with 59.6 million who quit or were discharged. Churn is especially strong in the retail and hospitality sectors, the two segments that account for the bulk of today’s shortfall in jobs. In April of this year, retailers hired nearly 800,000 workers. An additional 1.42 million workers found jobs in the leisure and hospitality sectors. This is equivalent to 5.3% and 10.1% of total employment in those sectors, respectively (Chart 23). And remember, we are talking about only one month’s worth of hiring. During past V-shaped recoveries, employment growth often surpassed 5% on a year-over-year basis (Chart 24). Such a growth rate would produce net 670K new jobs per month, enough to restore full employment by mid-2022. Chart 24V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries The Fed’s Three Criteria For Lift-Off In August of 2020, the Fed formally adopted a “flexible average inflation targeting” framework. It seeks to offset periods of below-target inflation with periods of above-target inflation. The goal is to better anchor long-term inflation expectations, while giving households and firms more clarity over where the price level will be many years out. In the spirit of this new framework, the Fed has made it clear that it needs to see three things before it considers raising rates: The labor market must be at “maximum employment” 12-month PCE inflation must be above 2% The FOMC must expect inflation to remain above 2% for some time If the US economy achieves full employment by the middle of next year, the first criterion will be satisfied. PCE inflation clocked in at 3.9% in May, so at least for now, the second criterion is satisfied as well. The big question concerns the third criterion. How Transitory Is US Inflation Likely To Be? As Chart 25 shows, more than half of the increase in the CPI in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI still remains below its pre-pandemic trend, while the level of the PCE deflator is barely above it (Chart 26). Aside from a few low-wage sectors such as retail and hospitality, overall wage growth remains contained. Neither the Atlanta Fed Wage Growth Tracker nor the Employment Cost Index – the two cleanest measures of US wage inflation – is signaling a brewing wage-price spiral (Chart 27). Chart 25Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI Chart 26AUnwinding Of "Base Effects" (I) Chart 26BUnwinding Of "Base Effects" (II) Chart 27No Sign Of A Wage-Price Spiral... For Now Chart 28Rising Oil Prices Have Fueled The Jump In Inflation Expectations   Chart 29Inflation Expectations Back Below The Fed's Target Zone Chart 30A Top In Inflation Expectations? While inflation expectations have risen, they should fall in the second half of the year as gasoline prices descend from their seasonal highs (Chart 28). Market expectations of inflation have already dipped back below the Fed’s comfort zone (Chart 29). Inflation expectations 5-to-10 years out in the University of Michigan’s Survey of Consumers also dropped from 3% in May to 2.8% in June (Chart 30). Overall producer price inflation should decline. Chart 31 shows that lumber prices, steel prices, agriculture prices, and memory chip prices have all peaked. Taken together, all this suggests that the recent surge in inflation is indeed likely to be “transitory.” Chart 31Input Prices Have Rolled Over Risk-Management Considerations Favor A “Go Slow” Approach Chart 32Market Participants See An Even Lower Terminal Rate Than The Fed The financial press often characterizes the Fed’s monetary policy as ultra-accommodative. With policy rates near zero, one would be forgiven for agreeing. However, the reality is that neither the Fed nor, for that matter, most market participants think that monetary policy is all that easy. Using expectations for the terminal Fed funds rate as a proxy for the neutral rate of interest, the Fed’s estimate of the terminal rate has fallen from 4.3% in 2012 to 2.5% at present (Chart 32). Surveys of primary dealers and other market participants suggest that investors think the terminal rate is even lower than what the Fed believes it to be. It is an open question as to whether the neutral rate really is as low as widely believed. But if it is, raising rates prematurely would be a grave mistake. Given the zero lower bound constraint on nominal policy rates, the Fed would be hard-pressed to ease monetary policy by enough to respond to any future deflationary shock. In contrast, if inflation proves to be more persistent, raising rates to cool the economy would be relatively straightforward. All this suggests that the Fed is likely to maintain its “go slow” approach. This publication expects tapering of QE to begin early next year, with no rate hike until December 2022 or early 2023. Other Central Banks Constrained By The Fed Chart 33Long-Term Inflation Expectations Remain Subdued The Fed’s dovish bias limits the ability of other developed economy central banks to tighten monetary policy. For some central banks, such as the ECB and BoJ, raising rates is the last thing they want to do. In both the euro area and Japan, long-term inflation expectations remain well below target (Chart 33). The Bank of England is in a better position to tighten monetary policy than the ECB. Inflation expectations are relatively high in the UK and a frothy housing market poses a long-term threat to economic stability. Nevertheless, the need to maintain a competitive currency to facilitate post-Brexit economic adjustments will limit the BoE’s ability to raise rates. Moreover, the departure of BoE Chief Economist, Andy Haldane, from the MPC will silence the sole voice sounding the alarm over rising inflation. Among the G7 economies, the Bank of Canada is the closest to raising rates. After a slow start, the vaccination campaign is now progressing well there. Property prices have gone through the roof. The Western Canada Select oil price has reached the highest level since 2014. The discount to WTI has shrunk from a peak over 50% in November 2018 to about 20% in recent weeks. The Bank of Canada has already begun tapering asset purchases. While concerns about a stronger loonie will tie the BoC’s hands to some extent, the first rate hike is still likely in mid-2022. II. Financial Markets A. Portfolio Strategy The Golden Rule embraced by this publication is “remain bullish on stocks as long as growth is likely to remain strong for the foreseeable future.” Historically, bear markets rarely occur outside of recessions (Chart 34). With both fiscal and monetary policy still supportive, and households in many countries sitting on plenty of dry powder, the odds that the global economy will experience a major downturn in the next 12 months are low. Chart 34Recessions And Bear Markets Tend To Overlap That said, we do acknowledge that the risk-reward profile for equities has deteriorated since the start of the year. Global stocks have risen 12% year-to-date, implying that investors have priced in an increasingly optimistic economic outlook. Our equity valuation indicator points to very poor long-term future returns, particularly in the US (Chart 35). Chart 35ALong-Term Expected Returns Are Nothing To Write Home About (I) Chart 35BLong-Term Expected Returns Are Nothing To Write Home About (II) Democrats in Congress will likely use the reconciliation process to raise corporate taxes. While this is unlikely to cause major problems for the economy, it could weigh on stocks. As we discussed in a past report, neither analyst earnings estimates nor market expectations are baking in much impact from higher tax rates. Meanwhile, economic growth has peaked in the US and China, and will peak in the other major economies over the balance of 2021. Slower growth is usually associated with lower overall equity returns (Table 2). Stocks are also likely to face headwinds as spending shifts back from goods to services. Goods producers are overrepresented in stock market indices compared to the broader economy. Table 2The Economic Cycle And Financial Assets The fact that global growth is peaking at exceptionally high levels will soften the blow for stocks. Likewise, the need to rebuild inventories and satisfy pent-up demand for some manufactured goods that have been in short supply will keep goods production from falling too drastically. Nevertheless, investors who have been maximally overweight stocks should consider paring exposure by raising cash. Only a modest equity overweight is appropriate going into the second half of this year. B. Equity Sectors, Regions, And Styles While we continue to favor cyclical equity sectors over defensives, non-US over the US, and value over growth, our conviction is lower than it was at the start of the year. In the near term, the lagged effects from the slowdown in Chinese credit growth could weigh on global cyclicals. Cyclicals could also stumble as the Delta variant rolls through the US and other countries. In addition, the US dollar could sustain recent gains as investors continue to fret that the Fed is turning hawkish. A stronger dollar is usually bad for cyclicals and non-US stocks (Chart 36). Chart 36Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 37Bank Shares Thrive in A Rising Yield Environment   Ultimately, as discussed earlier in this report, the Fed is likely to push back against the market’s hawkish interpretation of its dot plot. The resulting reflationary impulse should cause the dollar to weaken over a 12-month horizon while allowing for a re-steepening of the yield curve. Higher long-term bond yields tend to benefit banks, which are overrepresented in value indices (Chart 37). A stabilization in credit growth and more stimulative Chinese policy later this year should temper concerns about EM growth. Greater access to vaccines will also allow more EM economies to partake in reopening euphoria, thus benefiting local EM stock markets and global cyclicals. C. Fixed Income If stocks are pricey, government bonds are even more dear. Real yields are negative in most G10 economies. And while persistently higher inflation is not an imminent threat, it is a longer-term risk that bond valuations are not discounting. We expect the 10-year US Treasury yield to rise to 1.9% by the end of the year, above current market expectations of 1.61%. As of today, we are expressing this view by going short the 10-year Treasury note in our trade table. US Treasuries have a higher beta than most other government bond markets (Chart 38). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 38US Treasuries Have A Higher Beta Than Most Other Government Bond Markets BCA’s bond strategists see more upside from high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 2.9%. This is more than their fair-value default estimate of 2.3%-to-2.8% (Chart 39). It is also above the year-to-date realized default rate of 1.8%. Chart 39Spread-Implied Default Rate Our bond team sees USD-denominated EM corporate bonds as being attractively priced relative to domestic investment-grade corporate bonds with the same duration and credit rating. They prefer EM corporates to EM sovereigns in the A and Baa credit tiers, while preferring EM sovereigns over EM corporates in the Aa credit tier. Investors willing to take on foreign-exchange risk should consider EM local-currency bonds. As we discuss next, a weaker US dollar over the next 12 months should translate into stronger EM currencies. D. Currencies Four forces tend to drive the US dollar over cyclical horizons of about 12 months: Growth: As a countercyclical currency, the dollar typically does poorly when global growth is strong. This is especially the case when growth is rotating away from the US to other countries (Chart 40). Bloomberg consensus estimates imply that the US economy will transition from leader to laggard over the coming months, which is dollar bearish (Table 3). Chart 40The Dollar Is A Countercyclical Currency Table 3Growth Is Peaking, But At A Very High Level Interest Rate Differentials: The trade-weighted dollar tends to track the real 2-year spread between the US and its trading partners (Chart 41). It is unlikely that US real rates will fall much from current levels. However, the current level of spreads is already consistent with a meaningfully weaker dollar. Chart 41Rate Differentials Are A Headwind For The Dollar Balance Of Payments: The US trade deficit has increased significantly over the past year (Chart 42). Equity inflows have been helping to finance the trade deficit (Chart 43). However, if stronger growth abroad causes equity flows to move out of the US, the dollar will suffer. Chart 42The US Trade Deficit Has Increased Significantly Chart 43Equity Inflows Have Helped Finance The Trade Deficit Momentum: Being a contrarian is a losing strategy when it comes to trading the dollar. This is because the US dollar is a high momentum currency (Chart 44). The dollar usually continues to weaken when it is trading below its various moving averages and sentiment is bearish (Chart 45). At present, while the dollar is near its short-term moving averages, it is still below its long-term moving averages. Sentiment is bearish, but has come off its lows. On balance, the technical picture for the dollar is slightly negative.   Chart 44The Dollar Is A High Momentum Currency Chart 45ABeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Chart 45BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Adding it all up, we expect the dollar to weaken over a 12-month horizon. The dollar’s downdraft will likely begin in earnest during the fall when Chinese policy turns more stimulative and fears that the Fed has turned hawkish subside. We expect EUR/USD to finish the year at 1.25. GBP/USD should hit 1.50. Both EM and commodity currencies should also do better. The lone laggard among “fiat currencies” will be the yen. As a highly defensive currency, the yen usually struggles when global growth is firm. Chart 46To This Day, Most Crypto Payments Are Made To Criminals What about cryptocurrencies? I debated the topic with my colleague, Dhaval Joshi, in early June. To make a long story short, I think it is highly unlikely that cryptos will ever thrive. More than 13 years since Bitcoin was created, cryptos continue to be mainly used to facilitate illicit transactions. According to Chainalysis, there were fewer cryptocurrency payments processed by merchants in 2020 than in 2017 (Chart 46). Meanwhile, Bitcoin mining continues to produce significant environmental damage (Chart 47). And if there is any place where there is hyperinflation, it is in the creation of new cryptocurrencies. There are over 5000 cryptocurrencies at last count, double the number at this time last year (Chart 48). We are currently short Bitcoin in our trade table.   Chart 47Bitcoin And Ethereum: How Dare You! Chart 48Hyperinflation In New Cryptocurrency Creation E. Commodities Structurally, oil faces a bleak future. Transport accounts for about 60% of global oil consumption. The shift to electric vehicles will undermine this key source of oil demand. Cyclically, however, crude prices could still rise as the global economic recovery unfolds. Supply remains quite tight, reflecting both OPEC vigilance and the steep drop in oil and gas capex of recent years (Chart 49). Bob Ryan, BCA’s chief commodity strategist, expects Brent to rise to $79/bbl by the end of the year, which is 9% above current market expectations (Chart 50). Chart 49Oil And Gas Companies Curtailed Capex In Recent Years Chart 50Oil Prices Still Have Room To Run Chart 51Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom In contrast to oil, the long-term outlook for base metals is favorable. A typical electric vehicle requires four times as much copper as a typical gasoline-propelled vehicle. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of current annual copper production. Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then (Chart 51). In the near term, however, base metals have to grapple with the lagged effects of slower Chinese credit growth (Chart 52). We downgraded base metals to neutral on May 28 and are currently long global energy stocks via the IXC ETF versus global copper miners via the COPX ETF. We expect to reverse this trade by the fall. We are generally positive on gold. Since peaking last August, the price of gold has fallen more than one might have expected based on movements in real bond yields (Chart 53). Gold will also benefit from a weaker dollar later this year. Lastly, and importantly, gold should retain its standing as a good inflation hedge. Chart 52Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Chart 53Gold Prices Tend To Track Real Rates Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist   Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year.  Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone.  An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following:  First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022.  Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the first quarter of 2021 point towards easing standards in developed markets (Chart 1). Credit standards for business loans eased outright in most regions except for the euro area and New Zealand where the pace of tightening slowed significantly. On the whole, banks expected the easing trend to continue into Q2. Chart 1Credit Standards Moving Towards Or Deeper Into Easy Territory With credit spreads at historical tights, banks across the board cited increased competition from other lenders as a reason behind easing standards, confirming that easy financial conditions are not limited solely to booming financial markets. This will help maintain a market-friendly economic growth backdrop as developed economies put pandemic restrictions behind them. At the same time, an absence of tightening lending standards by commercial banks puts incremental pressure on central banks to move towards bond-bearish tightenings of monetary policy. An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and, thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As loan officers have access to detailed, non-public information on a large number of borrowers, they are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q1/2021 (Chart 3). Nearly 20% of respondents cited an improving or less uncertain economic outlook as a very important factor behind the decision to ease standards, while roughly one-third cited increased competition from other lenders. Chart 3US Credit Conditions Chart 4High-yield Borrowers Are Exposed To A Widening In Spreads Although it did not strengthen on net, C&I loan demand did weaken at a much slower pace in Q1. The factors driving loan demand suggest a buoyant economic backdrop—about a quarter of banks reporting increased demand cited merger and acquisition needs and increased investment as very important reasons. Meanwhile, weaker loan demand was attributed to less precautionary demand for cash and an increase in internally generated funds among customers. On the consumer side, loan demand improved slightly on the whole, driven largely by a significant improvement in auto loan demand. While consumer loan demand has historically correlated well with the year-over-year growth in personal consumption expenditures, those two series diverged remarkably in Q1, with spending growth far outpacing loan growth. This divergence reflects the tremendous impact of pandemic-related transfer payments and benefits. We expect a continued recovery in consumer lending demand as unemployment benefits are withdrawn and consumers once again have to borrow to finance spending. As part of the special ad-hoc questions in this edition of the survey, respondents were asked about how lending standards had changed compared to the pre-pandemic period by borrower risk rating. Interestingly, large banks actually eased their standards for investment grade borrowers, reflecting the impact of Fed’s massive liquidity injections (Chart 4). However, despite spreads on high-yield having tightened to post-GFC lows, credit standards for below-investment grade borrowers remain much tighter than before the pandemic. So far, lower-quality borrowers have been able to go to public debt markets for financing, but this highlights a downside risk—if there is an event which causes corporate bond spreads to widen, high-yield borrowers may be starved of cheap financing options with banks still holding purse strings taut. Euro Area In the euro area, banks continued to tighten standards to enterprises, albeit at a much-reduced pace, in Q1/2021 (Chart 5). The tightening, however, was lower than expected in the previous quarter, possibly reflecting prolonged policy support and improving risk sentiment. Deteriorating risk perceptions related to the general economic and firm-specific situation were the primary contributing factor to tightening. But this was partly offset by increased competition from other lenders. The reduced pace of tightening does confirm the signal from the high-yield default rate, which is rolling over. Going forward, banks expect the pace of tightening to slow very slightly going into Q2. Chart 5Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Business credit demand continued to weaken at a faster pace in Q1, marking three consecutive quarters of deterioration. Weak fixed investment continued to be the biggest drag on demand, while the previous positive contribution from inventory and working capital needs has disappeared entirely. As we highlighted in the last edition of this chartbook, the continued drag on demand for investment reflects a lingering uncertainty regarding the pandemic which could possibly lower potential long-term growth in the euro area.2 As in the US, however, the reduction in demand also reflected already built-up liquidity buffers and the availability of internal and market-based financing. In Q2, banks expect a strong rebound in enterprise loan demand, especially from small and medium-sized enterprises (SMEs). Consumer credit demand continued to decline at a stronger pace in Q1, reflecting the continued pandemic-related restrictions in Europe over the quarter. The key drivers were lower durable goods spending and weakening consumer confidence. Banks also reported increased use of internally-generated funds, which is consistent with accumulated savings and pent-up demand during the lockdown. Assuming that the emerging Delta variant does not sidetrack the European return to normalcy, we will likely see the expected consumer credit demand rebound come to fruition. This would be consistent with recent strong consumer confidence prints out of the region. Looking individually at the four major euro area economies, credit standards for enterprises tightened in Germany, Italy, and Spain but were unchanged in France (Chart 6). In countries where standards tightened, worsening risk perceptions were the primary factor. In France, increased competition from other lenders contributed to easing on the margin. Going into Q2, standards are expected to tighten very modestly in the two core European economies while diverging in peripheral Europe—Spanish banks expect an increased pace of tightening while Italian ones expect standards to remain unchanged. UK In the UK, overall corporate credit standards, measured as an average of standards for medium and large non-financial firms, eased slightly in Q1/2021 (Chart 7A). This increase in credit availability was driven primarily by an improving economic outlook and sector-specific risk picture. As in the US and euro area, competition from capital markets also played a role and is expected to contribute to the further easing expected in Q2. Chart 7AUK Credit Conditions Chart 7BInvestment And Inventory Financing Expected To Pick Up In The UK Meanwhile, corporate loan demand is picking up at a pace not seen since Brexit, excluding the 2020 spike driven by emergency funding needs, signaling a buoyant picture. In particular, the surge in demand was driven by large non-financial firms which are also expected to drive the demand pick-up in Q2. Household loan demand fell slightly in the first quarter but is expected to rebound. Consumer confidence, which had initially lagged behind loan demand, appears to have caught up as the UK’s “Freedom Day” from pandemic restrictions approaches in July. Lenders are also expected to ease availability for unsecured household loans, primarily on the back of market share objectives. This should create the ideal backdrop for a consumption boom if the Delta variant does not further limit the UK government’s ability to deliver on its promise of a full reopening. Delving into the factors behind booming corporate loan demand, there are promising signs for the broader UK economy (Chart 7B). In a Special Report published earlier this year, we argued that UK real interest rates were depressed because the country suffered from a series of rolling economic and political shocks, the effects of which were now expected to fade.3 There are already some signs of this in the credit data, with capital investment and inventory financing demand expected to rebound in Q2. Despite work-from-home effects dampening the need for office space, on the margin, UK commercial real estate demand is strong and expected to further strengthen. Japan Chart 8Japan Credit Conditions In Japan, credit standards to firms and households eased at a slower pace in Q1/2021 (Chart 8). The vast majority of respondents indicated that standards were basically unchanged, with none of the firms reporting any tightening, and a small number reporting some degree of easing. The most important factors driving easing were aggressive competition from other bank and non-bank lenders, as well as strengthened efforts to grow the business. Going into Q2, the pace of easing is expected to continue to slow. Business loan demand, which behaves somewhat counter-cyclically in Japan, increased over Q1. The entirety of this pickup can be attributed to small firms; large and medium-sized firms on the whole decreased their loan demand. Counter to trends in other regions, firms in Japan actually saw a decrease in internally-generated funds, which was the most important factor contributing to increased loan demand. Consumer loan demand fell slightly on balance but was mostly unchanged from the previous quarter. Respondents reporting weaker demand saw a decrease in household consumption as the most important factor. Sentiment remains subdued and has lagged the recovery in loan demand seen last year. Our colleagues at BCA Research Foreign Exchange Strategy are eyeing a recovery for the Japanese economy as the government turns around its vaccination campaign and the Olympics jumpstart consumption.4 On that basis, the very modest recovery in loan demand expected by Japanese banks appears too pessimistic. Canada And New Zealand In Canada, business lending standards continued to ease at a faster pace in Q1/2021, coinciding with rebounding business confidence which is now back to pre-pandemic levels (Chart 9). This is in line with a remarkable vaccine rollout—68% of the population has already received its first dose and the pace of daily vaccinations is showing no signs of rolling over. Chart 9Canada Credit Conditions Chart 10New Zealand Credit Conditions However, housing is a major concern for Canadian policymakers. In a recent Special Report, co-authored with our colleagues at The Bank Credit Analyst, we highlighted both Canada and New Zealand as “higher risk” countries more exposed to ballooning house prices.5 In addition to low rates, mortgage lending standards, which have been easing since Q3/2020, have undoubtedly contributed to this issue. However, the Bank of Canada (BoC), with its hawkish messaging, has signaled that it will not idly stand by; there is also popular support behind raising rates to tamp down house prices. Expect mortgage standards to tighten and a pick-up in mortgage rates as the BoC nears liftoff, most likely in 2022. Credit standards in New Zealand were mostly unchanged in Q1/2021, reversing the tightening trend of previous quarters (Chart 10). Over the next six months, standards are expected to ease considerably. Business loan demand was unchanged on net, with corporates decreasing and SMEs increasing demand. SMEs are also expected to increase demand slightly over the next six months. Tepid loan demand is consistent with business confidence hovering around the neutral zero line. As in Canada, soaring house prices are a major issue for the New Zealand economy. Data on household lending is alarming on that front. Although consumer loan demand continued to weaken, demand for residential mortgages spiked to an all-time high in Q1. While demand is expected to normalize going forward, the Q1 datapoint indicates froth in the market. The Reserve Bank of New Zealand is considering a variety of macroprudential measures but will have to raise rates sooner rather than later to effectively cool down the housing market. Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q1 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery", dated February 16, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. 4 Please see BCA Research Foreign Exchange Strategy Report, "The Case For Japan", dated June 11, 2021, available at fes.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com.

Highlights Spread Product: The macro environment is highly supportive for spread product and it will likely remain supportive for the next 12-18 months, at least until the yield curve flattens to below 50 bps. Remain overweight spread product versus Treasuries in US bond portfolios. High-Yield: High-yield spreads still look fairly valued, or even slightly cheap, compared to our base case outlook for corporate defaults. Investors should continue to favor high-yield over investment grade corporates and maintain an overweight allocation to high-yield in US bond portfolios. EM Corporates: Within the A and Baa credit tiers, US bond investors should favor USD-denominated EM corporates over USD-denominated EM sovereigns and should favor both over US corporate bonds. Within the Aa credit tier, investors should favor USD-denominated EM sovereigns over USD-denominated EM corporates and should favor both over US corporate bonds. Feature Chart 1Fed Meeting Didn't Shock Credit Markets Last week’s report looked at how the June FOMC meeting prompted a massive re-shaping of the Treasury curve.1 It didn’t discuss, however, the impact that June’s meeting had on credit spreads. There’s a simple reason for this. Corporate bond spreads didn’t move very much post-FOMC. In fact, neither investment grade nor high-yield spreads have widened significantly during the past two weeks, despite the Fed’s apparent “hawkish turn” (Chart 1). The VIX jumped briefly above 20 in the days following the Fed meeting but it has since re-discovered its lows (Chart 1, bottom panel). This week’s report considers whether the corporate bond market is too complacent. The first section updates our assessment of where we are in the credit cycle based on two indicators that did see large swings post-Fed. The second section updates our outlook for high-yield defaults and considers whether junk spreads continue to offer adequate compensation. Finally, the third section of this report presents an introductory look at valuation in the USD-denominated Emerging Market (EM) corporate sector. We find that, for the most part, investment grade EM corporates are attractively valued relative to EM sovereigns and US corporates of the same credit rating and duration. Credit Cycle Update Chart 2Credit Cycle Indicators As we have repeatedly stated in past research, the slope of the yield curve is a very important credit cycle indicator.2 We have documented that spread product tends to outperform duration-matched Treasuries by a wide margin when the yield curve is steep. This outperformance tapers off once the 3-year/10-year Treasury slope falls below 50 bps and it falls off even more when the slope dips below zero.3 With that in mind, it is notable that the Treasury curve flattened dramatically following the June FOMC meeting (Chart 2). At 106 bps, the 3-year/10-year Treasury slope remains well above the 50 bps threshold that would start to get concerning for spread product. However, it’s likely that the yield curve will continue to flatten as we approach a Fed rate hike in 2022. In other words, we expect that monetary conditions will turn sufficiently restrictive for us to reduce our recommended spread product allocation within the next 12-18 months. On the other hand, one positive development for spread product returns is that the 5-year/5-year forward TIPS breakeven inflation rate declined following the June FOMC meeting. In fact, it is now below the 2.3% to 2.5% range that is consistent with the Fed’s inflation target (Chart 2, bottom panel). This is a positive development for spread product because the Fed will strive to ensure that monetary conditions stay accommodative at least until these long-dated inflation expectations are consistent with the 2.3% to 2.5% target. Or put differently, a rebound in long-maturity TIPS breakeven inflation rates back to the target range will slow the near-term pace of curve flattening, giving the credit cycle a small amount of extra running room. In short, the macro environment is highly supportive for spread product and it will likely remain supportive for the next 12-18 months, at least until the yield curve flattens to below 50 bps. Investment Grade Corporates The highly supportive macro environment applies to investment grade corporate bonds, just as it does to all spread sectors. However, investment grade corporates have the problem that valuation is extremely tight. Much like a flat yield curve environment, a tight spread environment tends to coincide with low excess corporate bond returns. However, our research reveals that tight spreads alone are not sufficient for investment grade corporates to underperform duration-matched Treasuries. Table 1 classifies each month since May 1973 based on the investment grade corporate bond spread and the 3/10 Treasury slope. It then shows a 90% confidence interval for corporate bond excess returns during the following 12 months. It shows that, even when the corporate bond spread is below 100 bps (it is 81 bps today), investment grade corporates still tend to outperform duration-matched Treasuries as long as the 3/10 Treasury slope is above 50 bps. Table 1Expected 12-Month Corporate Bond Excess Return* (BPs) Based On OAS And Yield Curve Slope Bottom Line: The yield curve has started to flatten but it remains very steep, consistent with spread product outperforming duration-matched Treasuries. We remain overweight spread product versus Treasuries but will re-consider this position once the yield curve flattens to below 50 bps. We expect this could happen within the next 12-18 months. We maintain only a neutral allocation to investment grade corporate bonds because of stretched valuations. We see more attractive opportunities in high-yield corporates (see next section), municipal bonds, USD-denominated EM sovereigns and USD-denominated EM corporates (see final section below). High-Yield Default Update We last updated our default rate outlook in March.4 At that time, we concluded that junk spreads offered adequate compensation for expected default losses. Since then, we have received nonfinancial corporate sector profit and debt growth data for the first quarter of 2021, crucial inputs to our macro-based default rate model. Our macro-based model of the 12-month trailing speculative grade default rate is based on nonfinancial corporate sector gross leverage (i.e. pre-tax profits over total debt) and C&I lending standards (Chart 3). Lending standards enter our model with a lag, but we need a forward-looking estimate of gross leverage for our model to generate predictions. Chart 3Macro-Driven Default Rate Model To estimate gross leverage we first model corporate profit growth based on real GDP (Chart 4) and assume that real GDP grows by 7% over the next four quarters, consistent with the Fed’s median forecast. This gives us a profit growth expectation of roughly 30%. Chart 4Profit & Debt Growth We also need an estimate for corporate debt growth. Corporate debt exploded last year, growing 10% in 2020, but it then slowed to an annualized rate of 4% in Q1 2021. We think corporate debt growth will remain slow going forward. The nonfinancial corporate sector financing gap has been negative in each of the past four quarters (Chart 4, bottom panel), meaning that retained earnings have exceeded capital expenditures. In other words, firms have built up a lot of excess capital that can be deployed in place of debt to finance new investment opportunities. Table 2 shows our model’s predicted 12-month default rate based on different assumptions for profit and debt growth. If we assume corporate profit growth of 30% and corporate debt growth between 0% and 8%, then our model predicts that the 12-month default rate will fall from its current 5.5% to a range of 2.3% - 2.8%. Table 2Default Rate Scenarios Next, we need to consider what sort of expected default rate is priced into the High-Yield index. Our analysis of historical junk spreads and returns suggests that we should require a minimum excess spread of 100 bps in the High-Yield index after subtracting default losses to be confident that junk bonds will outperform Treasuries.5 If we also assume a recovery rate of 40% on defaulted debt, then we calculate that the High-Yield index is fairly priced for a 12-month default rate of 2.9% (Chart 5). That is, junk spreads appear slightly cheap compared to the 2.3% - 2.8% range predicted by our macro model.  Finally, it’s worth noting that actual corporate default events have been quite rare in recent months. In the first five months of 2021 we’ve seen between 1 and 3 default events per month. If we extrapolate that trend and assume we see 3 defaults per month going forward, then we calculate that the 12-month trailing default rate will fall to 2.0% by December, before leveling off at 2.2% (Chart 6). In other words, the recent trend has been one of significantly fewer defaults than predicted by our macro model Chart 5Spread-Implied Default Rate Chart 6Recent Default Trends Bottom Line: High-yield spreads still look fairly valued, or even slightly cheap, compared to our base case outlook for corporate defaults. Investors should continue to favor high-yield over investment grade corporates and maintain an overweight allocation to high-yield in US bond portfolios. An Attractive Opportunity In EM Corporates This week we present an introductory look at the risk/reward opportunity in USD-denominated EM corporate bonds. Specifically, we look at the investment grade Bloomberg Barclays USD-denominated EM Corporate & Quasi-Sovereign index. We compare this index to both the investment grade USD-denominated EM Sovereign index and the US Credit index.6 First, we look at recent performance trends and average index statistics (Table 3). Both the EM Corporate and EM Sovereign indexes have average credit ratings between A and Baa, so we compare their performance to the A-rated and Baa-rated US Credit indexes. We observe a significant option-adjusted spread (OAS) advantage in both the EM indexes, though part of the extra spread offered by the Sovereign index is compensation for its longer duration. The EM Corporate index sticks out as offering an extremely attractive OAS per unit of duration. Table 3Performance Trends & Index Statistics As for performance, we see that the EM Corporate index experienced less of a drawdown (in excess return terms) during the COVID recession, though it has also returned less than both the EM Sovereign index and the Baa Credit index during the recent upswing. Chart 7Spreads Versus Credit Rating & Duration-Matched US Credit Next, we look at each individual credit tier of both the EM Corporate & Quasi-Sovereign index and the EM Sovereign index, and we calculate the spread relative to a credit rating and duration-matched position in the US Credit index (Chart 7). In general, we see that both EM indexes offer a spread advantage versus duration-matched US Credit across all credit rating tiers. EM sovereigns look better than EM corporates in the Aa credit tier. This is the result of attractive spreads on the sovereign bonds of UAE and Qatar. However, EM corporates clearly dominate sovereigns in both the A and Baa credit tiers. Finally, we consider the risk/reward trade-off in our EM indexes by using our Excess Return Bond Map. Our Excess Return Bond Map shows the relationship between expected return (on the vertical axis) and risk (on the horizontal axis). In Chart 8A our risk measure is the 12-month spread widening required for each index to lose 100 bps versus a position in duration-matched Treasuries divided by that index’s historical spread volatility. It can be thought of as the number of standard deviations of spread widening required for the index to provide an excess return of -100 bps. A higher value corresponds to less risk, and vice-versa. Chart 8B uses the same risk measurement, only we use the spread widening required to lose 500 bps versus Treasuries to assess the risk of a large drawdown. Both Charts 8A and 8B use OAS as the measure of expected return. Chart 8AExcess Return Bond Map (100 BPs Loss Threshold) Chart 8BExcess Return Bond Map (500 BPs Loss Threshold) The first thing that sticks out in Charts 8A & 8B is that Baa-rated EM corporates offer greater expected return and less risk than the EM Sovereign index and the Baa US Credit Index. This is true whether our loss threshold is set at 100 bps or 500 bps. Unfortunately, we do not have sufficient data to split the EM Sovereign index by credit tier in these charts. A-rated EM corporates offer slightly less expected return than the EM Sovereign index but with significantly less risk, they also clearly dominate the A-rated US Credit Index. Aa-rated EM corporates appear to offer a similar risk/reward trade-off as the EM Sovereign index, though we know from Chart 7 that sovereigns have a spread advantage in the Aa credit tier. The bottom line is that USD-denominated EM corporates are attractively valued relative to investment grade US corporate bonds with the same duration and credit rating. EM corporates also look preferable to EM sovereigns in the A and Baa credit tiers. EM sovereigns are more attractive than EM corporates in the Aa credit tier. Within the A and Baa credit tiers, US bond investors should favor USD-denominated EM corporates over USD-denominated EM sovereigns and should favor both over US corporate bonds. Within the Aa credit tier, investors should favor USD-denominated EM sovereigns over USD-denominated EM corporates and should favor both over US corporate bonds. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 We use the 3-year/10-year Treasury slope in place of the more widely tracked 2-year/10-year slope in our credit cycle research only because using the 3-year/10-year slope allows us to include more historical cycles in our analysis. 4 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 5 Please see page 33 of the US Bond Strategy Quarterly Chartpack, “Testing The Limits Of Transitory Inflation”, dated May 18, 2021. 6 The US Credit Index consists predominantly of US corporate bonds, but also some non-corporate credit such as: Sovereigns, Foreign Agencies, Domestic Agencies, Local Authority bonds and Supranationals. Fixed Income Sector Performance Recommended Portfolio Specification

Feature Chart 1A Tug-Of-War In The US Treasury Market This week, we are publishing one of our periodic reports, covering global central bank lending standard surveys. Yet given some of the moves seen in US bond markets recently, we felt the need to also provide some additional thoughts, along with that previously scheduled report. The short-term volatility of longer-maturity US Treasury yields since the June 16 FOMC meeting has been a bit extreme, to say the least. The 30-year yield fell from an intraday peak of 2.21% just before the Fed meeting to an intraday low of 1.93% on June 21, a 28bp plunge in a span of just three trading days, but has climbed back to 2.10% as we go to press. Over that same time frame, shorter maturity yields have been relatively more stable. After the 5-year yield rose from 0.78% on 0.93% immediately following the “hawkish” Fed surprise on FOMC Day, the yield has largely held those gains, hitting only a brief intraday low of 0.84% on June 21, and now sits at 0.90%. This price action is consistent with the two opposing forces currently at work in the US Treasury market. Investors are slowly repricing the expected path of Fed policy, pulling forward the liftoff date of the fed funds rate in line with the new “guidance” from the FOMC interest rate forecasts. This is putting upward pressure on the shorter maturity part of the Treasury curve. At the same time, the market continues to work off the deeply oversold condition that had developed in longer-maturity Treasuries, as we discussed in a recent report.1 The sharp volatility of the 30yr yield is consistent with a rapid adjustment of positioning, which had become very short when looking at measures like the CFTC data on 30-year bond futures net positioning (Chart 1). Chart 2Corporate Bond Investors Appear Far Less Worried Than Equity Investors Once that overhang of short positioning in longer maturity yields is worked off, the overall Treasury yield curve will begin moving higher again, continuing the cyclical bear market. The next increase in yields, however, will look different than what occurred between August 2020 and March 2021, when rising growth and inflation expectations resulted in a bearish steepening of the Treasury curve. The next move will be led by yields rising more at the front end of the curve, as the Fed begins the long march toward policy normalization. This will result in a bearish flattening of the Treasury curve, which motivated us to introduce a new US yield curve trade last week along with our colleagues at BCA Research US Bond Strategy – going short a 5-year bullet versus going long a duration-matched 2-year/10-year barbell. We have added that trade to our Tactical Overlay portfolio using specific on-the-run Treasury bonds, as can be seen in the table on page 7.2 While yields are jumping around in government bond markets, credit markets remain calm. Corporate bond spreads have been grinding tighter, in line with the steady decline in the VIX index of US equity volatility (Chart 2). Yet investors in other asset classes are exhibiting more cautious optimism. The soaring SKEW index has climbed to an all-time high, suggesting that demand for downside portfolio protection via S&P 500 put options is very robust with the equity index also at an all-time high. However, with the VIX falling, economic growth remaining solid, bank lending standards easing and the Fed not expected to even begin tapering its asset purchases until the start of 2022, the backdrop remains generally positive for US corporate debt versus US Treasuries. Next week, we will be presenting our quarterly review of the Global Fixed Income Strategy model bond portfolio, where we will present our base case and tail risk scenarios for global bond markets over the remaining months of 2021, along with our recommended portfolio positioning.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, “A Summer Nap For Global Bond Yields”, dated June 9, 2021, available at gfis.bcaresearch.com. 2 Please see BCA Research US Bond Strategy/Global Fixed Income Strategy Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns