Gov Sovereigns/Treasurys

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Highlights There is no evidence of a decline in US corporate credit or bank lending spreads over the past few decades, meaning that any excess savings effect structurally depressing interest rates is occurring in the Treasury market. We note the possible mechanisms of action for excess savings to lower government bond yields, by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. To investigate the impact that excess savings may be having on bond yields, we define historical periods of abnormal yields based on the gap between long-maturity Treasury yields and the potential rate of economic growth. This reflects our view that potential growth is the equilibrium interest rate under normal economic conditions. Since 1960, there have been three major episodes when the difference between bond yields and economic growth was large and persistent, but the first two seem to be easily explained by the stance of US monetary policy rather than by a savings/investment imbalance. The excess savings story better fits the facts after 2000. We do find evidence that a global savings glut lowered bond yields during the early-2000s, and it may have even modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, the effect of the global savings glut was relatively insignificant compared to what has prevailed over the past decade. Excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so for cyclical reasons that spanned several years rather than as a result of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, as long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion despite a reduction in savings and significantly stronger growth. The historical impact of FOMC meetings on the structural decline in long-maturity US Treasury yields strongly implies that fixed-income investors have been guided by the Fed to expect a lower average Fed funds rate. It is our view that the Fed has a backward-looking neutral rate outlook, informed by an incomplete understanding of the economic circumstances of the latter half of the last expansion. A low neutral rate narrative has become entrenched in the minds of investors and the Fed itself, and we regard this as the primary factor anchoring yields at the long-end of the maturity spectrum. This phenomenon is only likely to dissipate once short-term interest rates rise and a recession does not materialize. While the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Feature Chart II-110-Year US Treasury Yields Are The Lowest Relative To Headline Inflation In Over 60 Years 10-Year US Treasury Yields Are The Lowest Relative To Headline Inflation In Over 60 Years 10-Year US Treasury Yields Are The Lowest Relative To Headline Inflation In Over 60 Years For many investors, one of the most striking features of the pandemic, especially over the past year, is how low US long-maturity government bond yields have remained in the face of the highest headline consumer price inflation in four decades (Chart II-1). To many investors, this has provided even further evidence of a structural “excess savings” effect that has kept interest rates well below the prevailing rate of economic activity. The theory of secular stagnation, revived by Larry Summers in late 2013, is a related concept, but many investors believe that interest rates will remain low even in a world in which the US economy is growing at or even above its trend. The fundamental basis for this view is the idea that over the longer term, the real rate of interest is determined by the balance (or imbalance) between desired savings and investment, and that advanced economies have and will continue to experience excess savings – defined as a chronically high level of desired savings relative to the investment opportunities available. According to this view, in order for the actual level of savings to equal investment, interest rates must fall. Chart II-2Do Excess Savings Explain This Gap? (Spoiler: No) Do Excess Savings Explain This Gap? (Spoiler: No) Do Excess Savings Explain This Gap? (Spoiler: No) This report challenges the view that excess savings are mostly responsible for the current level of long-term bond yields in the US. We agree that excess savings have played a role in explaining changes in long-term bond yields at different points over the past 20 years; we also agree that it is normal for interest rates in advanced economies to trend down over time in response to a demographically-driven decline in potential growth. But our goal is not to explain the downtrend in interest rates over time. Instead, we aim to explain the gap between the level of long-term bond yields today and the prevailing rate of economic activity, or consensus forecasts of the trend rate of growth (Chart II-2). We do not believe that this gap is economically justified, nor do we believe that it is driven by excess savings. We conclude that the Fed’s backward-looking neutral rate outlook is the primary factor anchoring US Treasury yields at the long-end of the maturity spectrum. This is only likely to change once short-term interest rates rise and a recession does not materialize; it suggests that investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Excess Savings And Interest Rates: Defining A “Mechanism Of Action” Households, businesses, and governments can directly purchase debt securities in capital markets, but they do not typically provide loans directly to borrowers. Direct lending usually occurs through the banking system, which means that excess savings would only lower interest rates in the economy through one of the following ways: By lowering the Fed funds rate By lowering long-maturity government bond yields relative to the Fed funds rate, by reducing either the term premium or investors’ expectations for the average Fed funds rate in the future By lowering corporate bond yields relative to duration-matched government bond yields By lowering lending rates on bank loans relative to banks’ cost of borrowing Charts II-3-II-5 highlight that there is no evidence of a structural decline in corporate credit spreads or bank lending rates relative to the Fed funds rate, so we can rule out this effect as a mechanism of action for excess savings to have structurally lowered interest rates. Chart II-6 highlights that interest paid on bank deposits lags the Fed funds rate, so we can also rule out the idea that excess deposits force the Fed to keep the effective Fed funds rate low. Chart II-3No Evidence Of A Structural Decline In Corporate Credit Spreads… No Evidence Of A Structural Decline In Corporate Credit Spreads... No Evidence Of A Structural Decline In Corporate Credit Spreads... Chart II-4…Or Auto Loan Rate Spreads… ...Or Auto Loan Rates Spreads... ...Or Auto Loan Rates Spreads... Chart II-5…Or Personal Loan Rate Spreads… ...Or Personal Loan Rate Spreads... ...Or Personal Loan Rate Spreads... Chart II-6...Or Bank Deposit Rate Spreads ...Or Bank Deposit Rate Spreads ...Or Bank Deposit Rate Spreads This means that if excess savings are depressing interest rates in the US, that the effect is truly occurring in the Treasury market. As noted, this could occur by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. Related Report  The Bank Credit AnalystR-star, And The Structural Risk To Stocks All of these effects are certainly possible. Keynes’ paradox of thrift highlights that excess savings can manifest itself as a chronic shortfall in aggregate demand, which would persistently lower the Fed funds rate as the Fed responds to a long period of high unemployment. This could also lower the term premium on long-maturity bond yields in a scenario in which the Fed repeatedly engages in asset purchases to help stabilize aggregate demand. As well, domestic excess savings could lower the term premium on long-maturity bond yields, as aging savers directly purchase government securities as part of their retirement portfolios. Finally, foreign capital inflows could also cause this effect, especially if they originate from countries with chronic current account surpluses that use an increase in US dollar reserves to purchase long-maturity US government securities. Table II-1 summarizes these possible mechanisms of action for excess savings to lower US government bond yields. With these mechanisms in mind, we review the past 60 years to identify periods of “abnormal” bond yields, with the goal of understanding whether excess savings appear to explain major gaps. Table II-1Possible Mechanisms Of Action For Excess Savings To Lower Long-Term Government Bond Yields April 2022 April 2022 Identifying Periods Of “Abnormal” Long-Maturity Bond Yields Chart II-7There Have Been Three Distinct Periods Of Abnormal Long-Maturity Bond Yields There Have Been Three Distinct Periods Of Abnormal Long-Maturity Bond Yields There Have Been Three Distinct Periods Of Abnormal Long-Maturity Bond Yields Chart II-7 shows the difference between nominal 10-year US Treasury yields and nominal potential GDP growth. Panel 2 shows an alternative version of this series using the ten-year median annualized quarterly growth rate of nominal GDP in lieu of estimates of potential growth, which highlights a generally similar relationship. This approach to defining “abnormal” long-maturity bond yields reflects our view that the potential rate of economic growth is the equilibrium interest rate under normal economic conditions. To see why, given that GDP also effectively represents gross domestic income, an interest rate that is persistently below the potential growth rate of the economy would create a strong incentive to borrow on the part of households and especially firms. Chart II-7 makes it clear that the relationship has been mean-reverting over time, but that there have been three major episodes when the difference between bond yields and economic growth was large and persistent. The first episode occurred from 1960 to the late 1970s, and saw government bond yields average well below the prevailing rate of economic growth. We do not see this period as having been caused by an excess of desired savings relative to investment. As we discussed in our November Special Report,1 this gap represented a period of persistently easy monetary policy which contributed to excessive aggregate demand and a structural rise in inflation. The second major episode is also easily explained, as it occurred in response to the first. Following a decade of high inflation, Fed chair Paul Volcker raised interest rates aggressively beginning in 1979 to combat inflationary expectations, which led to a two-decade period of generally tight monetary policy. Like the first period, this was not caused by an imbalance between desired savings and investment. The third episode has prevailed since the late-1990s, and has seen a negative yield/growth gap on average – albeit one that has been smaller than what occurred in the 1960s and 1970s. From 2000 to 2007, the gap was generally negative, although it turned positive by the end of the economic cycle. It was modestly negative on average from 2008 to 2010, and only became persistently negative starting in 2011. The gap fell to a new low during the COVID-19 pandemic, and remains wider today than at any point during the last economic recovery. It is these post-2000 periods of a persistently negative yield/growth gap that should be closely investigated for evidence of an excess savings effect. The Global Savings Glut As noted, prior to 2000, the yield/growth gap in the US seems clearly explained by the Fed’s monetary policy stance, not by an excess savings effect. So the question is whether there is any evidence of excess savings having caused this negative gap since 2000. In our view, the answer is yes, but the effect was relatively small compared to what prevails today. We do find evidence of a global savings glut during the early-2000s. Chart II-8 highlights that the private and external sector savings/investment balances in China and emerging markets more generally were persistently positive during the 2000s. Chart II-9 highlights that multiple estimates of the term premium declined around that time – especially during Greenspan’s “conundrum” period of between 2004 and 2005. Chart II-8There Was A Global Savings Glut Prior To The Global Financial Crisis There Was A Global Savings Glut Prior To The Global Financial Crisis There Was A Global Savings Glut Prior To The Global Financial Crisis Chart II-9The Global Savings Glut Does Seem To Have Lowered The Term Premium On US 10-Year Treasurys The Global Savings Glut Does Seem To Have Lowered The Term Premium On US 10-Year Treasurys The Global Savings Glut Does Seem To Have Lowered The Term Premium On US 10-Year Treasurys Chart II-10 breaks down the components of the 10-year yield into the 5-year yield and the 5-year/5-year forward yield, and highlights that the negative correlation between the two components lasted for only one year. Overall, the 10-year Treasury yield was lower than potential growth for roughly two years as a result of the global savings glut effect.       Chart II-10Still, The Global Savings Glut Effect Did Not Last Long And Was Not Especially Large In Magnitude Still, The Global Savings Glut Effect Did Not Last Long And Was Not Especially Large In Magnitude Still, The Global Savings Glut Effect Did Not Last Long And Was Not Especially Large In Magnitude This was a significant event, and it may even have modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, it was relatively insignificant compared to what has prevailed over the past decade. Excess Savings And US Household Deleveraging Chart II-11Most Of The Post-2007 Decline In 10-Year Yields Is Attributable To Lower Long-Term Fed Funds Rate Expectations Most Of The Post-2007 Decline In 10-Year Yields Is Attributable To Lower Long-Term Fed Funds Rate Expectations Most Of The Post-2007 Decline In 10-Year Yields Is Attributable To Lower Long-Term Fed Funds Rate Expectations Chart II-11 highlights that, relative to June 2007 levels, the vast majority of the cumulative decline in the 10-year Treasury yield has occurred because of a decline in implied long-term expectations for the Fed funds rate, rather than a major decline in the term premium. The chart also shows that almost all the decline in implied long-term interest rate expectations since 2007 occurred during the 2008/2009 recession. This normally occurs during a recession as investors price in a low average Fed funds rate at the short end of the curve; the anomaly is that these expectations remained permanently low even as the economy recovered and as the Fed raised interest rates from 2015 to 2018. To us, Chart II-11 also underscores that the Fed’s asset purchases are not the main culprit behind low long-maturity bond yields today, given that the decline in long-term expectations for the Fed funds rate persisted even as the Fed stopped purchasing assets in 2014. It is not difficult to see why investors lowered their long-term Fed funds rate expectations in the immediate aftermath of the global financial crisis, even as economic recovery took hold. Chart II-12 highlights that the “balance sheet” nature of the 2008/2009 recession unleashed the longest period of US household deleveraging in the post-WWII period, and Chart II-13 highlights that this occurred despite extremely low interest rates – and in contrast to other countries like Canada that did not experience the same loss in household net worth. Chart II-12Household Deleveraging Did Lower The Neutral Rate For Several Years Following The Global Financial Crisis Household Deleveraging Did Lower The Neutral Rate For Several Years Following The Global Financial Crisis Household Deleveraging Did Lower The Neutral Rate For Several Years Following The Global Financial Crisis Chart II-13The US Balance Sheet Recession Structurally Impaired Credit Demand For Several Years After 2008 The US Balance Sheet Recession Structurally Impaired Credit Demand For Several Years After 2008 The US Balance Sheet Recession Structurally Impaired Credit Demand For Several Years After 2008     Given that interest rates represent the price of borrowing, it is entirely unsurprising that a US balance sheet recession led to a persistent period in which credit growth was essentially unresponsive to interest rates, as households struggled to rebuild wealth lost during the recession and were unable to, or uninterested in, releveraging. This is another way of saying that the neutral rate of interest fell during that period, which we agree did occur. It is also accurate to characterize the US as having experienced a sharp increase in desired savings over that period, as highlighted by the explosion in the US private sector financial balance in the initial years of the last economic recovery (Chart II-14). Chart II-14Excess Savings Surged After 2008, But Eventually Normalized. Long-Term Rate Expectations Ignored The Normalization. Excess Savings Surged After 2008, But Eventually Normalized. Long-Term Rate Expectations Ignored The Normalization. Excess Savings Surged After 2008, But Eventually Normalized. Long-Term Rate Expectations Ignored The Normalization. So excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so because of cyclical reasons that spanned several years rather than because of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, because while Chart II-14 shows that this excess savings effect eventually waned in importance, long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion. Chart II-15Growth Was Historically Weak Last Cycle, But Only Because Of The First Few Years Of The Expansion April 2022 April 2022 Chart II-15 highlights that the cumulative annualized growth in real per capita GDP during the last economic cycle was significantly below that of the average of previous expansions, but this was only the case because of the very slow growth period between 2008 and 2014. Per capita growth during the latter half of the expansion was comparable to that of previous expansions, and this occurred while the Fed was raising interest rates. And yet, investors only modestly raised their long-term interest rate expectations during that period. In our view, it is this fact that holds the key to understanding why investors’ long-term rate expectations are still low today. An Alternative Explanation For Today’s Extremely Low Long-Maturity Bond Yields Chart II-16Fixed-Income Investors Have Been Guided By The Fed To Expect A Low Average Fed Funds Rate Fixed-Income Investors Have Been Guided By The Fed To Expect A Low Average Fed Funds Rate Fixed-Income Investors Have Been Guided By The Fed To Expect A Low Average Fed Funds Rate Chart II-16 highlights that, since 1990, all of the structural decline in US 10-year Treasury yields has occurred within a three-day window on either side of FOMC meetings. This strongly suggests that fixed-income investors have been guided by the Fed to expect a low average Fed funds rate, which is consistent with how similar 5-year/5-year forward US Treasury yields are in relation to published FOMC and market participant estimates of the average longer-run Fed funds rate (as shown in Chart II-2). This raises the important question of why the Fed did not revise up its expectation for the neutral rate during or following the second half of the last economic expansion, when growth was much stronger than during the first half. In our view, one of the clearest articulations of the Federal Reserve’s understanding of the neutral rate of interest was presented in a 2015 speech by Lael Brainard at the Stanford Institute for Economic Policy Research. Brainard noted the following: “The neutral rate of interest is not directly observable, but we can back out an estimate of the neutral rate by relying on the observation that output should grow faster relative to potential growth the lower the federal funds rate is relative to the nominal neutral rate. In today’s circumstances, the fact that the US economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now. In fact, various econometric estimates of the level of the neutral rate, or similar concepts, are consistent with the low levels suggested by this simple heuristic approach.”2 Chart II-17The Fed, Wrongly, Sees The 2019 Experience As Having Confirmed A Low Neutral Rate... The Fed, Wrongly, Sees The 2019 Experience As Having Confirmed A Low Neutral Rate... The Fed, Wrongly, Sees The 2019 Experience As Having Confirmed A Low Neutral Rate... Given how the Fed determines the neutral rate is, two factors explain why the Fed’s estimates of the neutral rate have not increased (and, in fact, fell modestly in March). First, core inflation remained below 2% from 2015-2019, despite the fact that the economy was clearly growing at an above-trend pace during this period in the face of Fed rate hikes. We have noted in previous reports the role that the 2014 collapse in oil prices had on household inflation expectations. The latter were already vulnerable to a disinflationary shock, given how negative the output gap had been in the first half of the expansion.3 We do not think that the decline in inflation expectations that occurred following the 2014 collapse in oil prices reflects a low neutral rate, but rather we believe that the Fed saw this as a conundrum that supported the expectation of a low average Fed funds rate. The second event explaining the Fed’s persistently low long-term rate expectations is the fact that the Fed was forced to cut interest rates in 2019, which we believe it saw as confirmation that the stance of monetary policy had become either meaningfully less easy or openly tight. From the Fed’s point of view, this perspective was also supported by recessionary indicators, such as the inversion of the 2-10 yield curve (Chart II-17), and popular (but now discontinued) econometric estimates of the real neutral rate of interest, such as those calculated by the Laubach-Williams model (panel 3). Chart II-18...Without Appreciating The Damaging Impact The China-US Trade War Had On Global Activity ...Without Appreciating The Damaging Impact The China-US Trade War Had On Global Activity ...Without Appreciating The Damaging Impact The China-US Trade War Had On Global Activity However, this view entirely ignores the fact that the US and global economies were negatively impacted in 2018 and 2019 by a politically-motivated nonmonetary shock to aggregate demand: the China-US trade war, which also impacted or targeted several major advanced economies. Chart II-18 highlights that global trade uncertainty exploded during this period, which severely damaged business confidence around the world and caused a slowdown in global industrial production. Tighter Chinese policy also likely contributed to the slowdown in global activity, but the bottom line is that factors other than US monetary policy contributed to economic weakness during this period, and that it is incorrect to infer from the 2018/2019 experience that interest rates rose to or exceeded the neutral rate of interest. In short, it is our view that the Fed has simply become backward-looking in how it perceives the neutral rate of interest; it has not yet observed a period when the Fed funds rate has risen to its estimate of neutral but is unambiguously still easy. Fixed-income investors, having demonstrably anchored their own assessments to those of the Fed over the past 30 years, have had no basis to come to a meaningfully different conclusion. We believe that the Fed’s backward-looking low neutral rate outlook has now become entrenched in the minds of investors and the Fed itself, and is the primary factor anchoring yields at the long-end of the maturity spectrum. This will probably only change once short-term interest rates rise and a recession does not materialize. As a final point, we clearly acknowledge that private savings increased massively during the pandemic. Investors who are inclined to see excess savings as the primary driver of low bond yields will point to this fact. But this was a forced increase in savings, rather than a desired one. The rise in household sector savings occurred mostly because of a substantial reduction in services spending, as pandemic restrictions and forced changes in behavior prevented the consumption of many services. The household savings rate has already returned to its pre-pandemic level in the US, and 5-year/5-year forward Treasury yields have risen to a higher point than they were prior to the onset of the COVID-19 pandemic. US households are likely to deploy a portion of their enormous stock of excess savings, as the pandemic continues to recede in importance, which is one of the main reasons to expect that the US economy will not succumb to a recession over the coming 12-18 months – and why investors and the Fed may soon be presented with evidence that warrants an increase in their long-term interest rate expectations. Investment Conclusions There are two important investment implications of the view that the Fed’s backward-looking neutral rate projection is the primary factor anchoring yields at the long end of the maturity spectrum. As we noted in Section 1 of our report, the first implication is that investors will likely be faced with a recession scare as the 2-10 yield curve durably inverts and as rate sensitive sectors of the economy, such as housing, inevitably slow in response to the extremely sharp rise in mortgage rates that has occurred over the past three months. We believe that it is ultimately the level of interest rates that matters for economic activity, rather than the change in interest rates. Large changes over short periods of time, however, create a degree of uncertainty about the trajectory of rates that temporarily impacts economic activity. This underscores that investors should not maintain an aggressively overweight stance toward global equities in a multi-asset portfolio, as it is likely that concerns about corporate profits will increase significantly at some point this year. The second investment implication is that US long-maturity bond yields could increase to much higher levels over the coming 12-24 months than many investors expect, in a scenario in which pandemic-driven price pressure dissipates, real wages recover, and no major politically-driven nonmonetary policy shocks emerge. We acknowledge that long-term interest rate expectations are unlikely to change until hard evidence of the economy’s capacity to tolerate interest rates above the Fed’s implied current estimate of the neutral rate emerges. This is a case, however, when we believe that investors should heed the now-famous words of Rüdiger Dornbusch: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” As such, while the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2 Lael Brainard, Normalizing Monetary Policy When The Neutral Rate Is Low, December 2015 3 Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com

Executive Summary Refreshing Our Tactical Trade List A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Our current list of tactical trade recommendations centers around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We still see value in holding our recommended cross-country spread trades that will benefit from continued US bond underperformance (short US Treasuries versus government bonds in Germany, Canada and New Zealand, all at the 10-year maturity). We also maintain our bias to lean against the yield curve flattening trend in the US, but we now prefer to do it solely via our existing SOFR futures calendar spread position. Finding attractively valued inflation breakeven spread trades is more difficult after the latest oil-fueled run-up in developed market inflation expectations. Canadian breakevens, however, stand out as having the greatest upside potential according to our Comprehensive Breakeven Indicators. Bottom Line: Remain in US-Germany, US-Canada an US-New Zealand 10-year government bond yield spread widening trades. Maintain our recommended position in the US SOFR futures curve (long Dec/22 futures, short Dec/24 futures). Add a new inflation-linked bond trade, going long 10-year Canadian breakevens. Feature One month has passed since Russia invaded Ukraine, and investors are still struggling to sort out the financial market implications. Equity markets in the US and Europe have recovered the losses incurred immediately after the conflict began. Equity market volatility has also fallen back to pre-invasion levels according to the VIX index (and its European counterpart, the VStoxx index). That decline in equity volatility has also coincided with a narrowing of corporate credit spreads in both the US and Europe, with the former now fully back to pre-invasion levels. Yet while credit spread volatility has calmed down, government bond yield volatility remains elevated thanks to rising commodity prices putting upward pressure on expectations for inflation and monetary policy (Chart 1). Chart 1Global Bond Yields Are Above Pre-Invasion Levels Global Bond Yields Are Above Pre-Invasion Levels Global Bond Yields Are Above Pre-Invasion Levels ​​​​​​ Table 1Refreshing Our Tactical Trade List A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations We have already made some “wartime” adjustments to our global bond market cyclical recommendations, with those changes reflected in our model bond portfolio. This week, we review our shorter-term tactical trade recommendations. Our current list of tactical trades revolves around two broad themes that predate the Ukraine conflict – rising global inflation expectations and relatively stronger cyclical upward pressure on US interest rates. Both themes have been strengthened by the spillovers from the war in Eastern Europe, most notably the link between soaring commodity prices and rising inflation. We continue to see the value in holding on to most of our existing tactical trades, with only a couple of adjustments to be made to our US yield curve and global inflation-linked bond positions (Table 1). US Yield Curve Tactical Trades: Shift Focus To SOFR Steepeners We have recommended trades that lean against the aggressive flattening of the US Treasury curve discounted in forward rates since late 2021. Our view has been that markets were discounting too rapid a pace of Fed rate increases in 2022. With the Fed likely delivering fewer hikes than expected, Treasury curve steepening trades would benefit as the spot Treasury curve would flatten by less than implied by the forwards. Related Report  Global Fixed Income StrategyFive Reasons To Tactically Increase US Duration Exposure Now Needless to say, that view has not panned out as we anticipated. The spread between 10-year and 2-year US Treasury yields now sits at a mere +13bps, down from +104bps when we initiated our 2-year/10-year steepener trade last November. The forwards now discount an inversion of that curve starting in June of this year, which would be an extraordinary outcome by historical standards. Typically, the US Treasury curve inverts only after the Fed has delivered an extended monetary tightening cycle that delivers multiple rate hikes over at least a 1-2 year period (Chart 2). Today, the curve has nearly inverted with the Fed having only delivered only a single 25bp rate increase earlier this month. Chart 2The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now The UST Curve Is Unusually Flat Right Now Of course, the Fed’s reaction function in the current cycle is different compared to the past. The Fed now follows an average inflation targeting framework that tolerates temporary inflation overshoots after periods when US inflation ran below the Fed’s 2% target. Now, however, the Fed has no choice but to respond to surging US inflation, which has been accelerating since September and is now at levels last seen in 1982. Chart 3Our SOFR Trade Is Similar To Our UST Curve Trade Our SOFR Trade Is Similar To Our UST Curve Trade Our SOFR Trade Is Similar To Our UST Curve Trade We still see the market pricing in too much Fed tightening this year and too few rate hikes in 2023/24. The US overnight index swap (OIS) curve now discounts 218bps of rate hikes in 2022, but 44bps of rate cuts between June 2023 and December 2024. We think a more likely scenario is the Fed doing less than discounted this year, as US inflation should show some deceleration in the latter half of 2022, but then continuing to raise rates in 2023 into 2024. We have expressed this view more specifically through an additional tactical trade that was initiated last month, going long the December 2022 3-month SOFR futures contract versus shorting the December 2024 3-month SOFR futures contract. This new trade is essentially a calendar spread trade between two futures contracts, but with a return profile that has looked quite similar to our 2-year/10-year US Treasury curve flattening trade (Chart 3). Having two tactical trades that are highly correlated, and which both are driven by the same theme of the Fed doing less this year and more over the next two years, is inefficient. We see the SOFR calendar spread trade as a more precise expression of our Fed policy view compared to the 2-year/10-year Treasury curve steepener. In addition, the SOFR trade now offers slightly better value after it has lagged the performance of the Treasury curve trade over the past couple of weeks. Thus, we are keeping this trade in our Tactical Overlay portfolio (see the table on page 15), while closing out our 2-year/10-year steepener at a loss of -92bps.1 Cross-Country Spread Trades: Keeping Betting On Relatively Higher US Yields In our Tactical Overlay portfolio, we currently have three recommended cross-country government bond spread trades that all have one thing in common – a sale of 10-year US Treasuries. The long side of the three trades are different (Germany, New Zealand and Canada), but the logic underlying all three trades is the same. The Fed will deliver more rate hikes than the central banks in the other countries. 10-year US Treasury-German Bund spread Chart 4UST-Bund Spread Is Too Low UST-Bund Spread Is Too Low UST-Bund Spread Is Too Low Expecting a wider US Treasury-German Bund spread remains our highest conviction view in G-10 government bond markets. This is a trade we have described as a more efficient way to position for rising US bond yields than a pure below-benchmark US duration stance. We have maintained that recommendation in both our model bond portfolio and our Tactical Overlay portfolio. For the latter, that trade was implemented using 10-year bond futures in both markets and is up 3.9% since initiation back in October 2021. The case for expecting even more Treasury-Bund spread widening remains strong, for several reasons: Underlying inflation remains higher in the US, particularly when looking at domestic sources of inflation like wages and service sector prices. Europe, which relies more heavily on Russia for its energy supplies than the US, is more at risk of a negative growth shock from the Ukraine conflict. Our fundamental model of the 10-year Treasury-Bund spread shows that the current level of the spread (+197bps) is about one full standard deviation below fair value, which itself is rising due to stronger US economic growth, faster US inflation and a more aggressive path for monetary tightening from the Fed relative to the ECB (Chart 4). The spread between our 24-month discounters in the US and Europe, which measure the amount of rate hikes priced into OIS curves for the two regions over the next two years, has proven to be good leading indicator of the 10-year Treasury-Bund spread. That discounter spread is currently at 99bps, levels last seen when the 10-year Treasury-Bund spread climbed to the 250-300bps range in 2017/18 (Chart 5). With the relative forward curves now discounting a slight narrowing of the US-German 10-year spread over the next year, betting on a wider spread does not suffer from negative carry. We are maintaining this trade in our Tactical Overlay portfolio with great conviction. 10-year US Treasury-Canada government bond spread We entered another cross-country spread trade involving a US Treasury short position earlier this month, in this case versus 10-year Canadian government bonds. This trade is a bet on relative monetary policy moves between the Fed and the Bank of Canada (BoC). Like the Fed, the BoC is facing a problem of high inflation and tight labor markets. Canadian core CPI inflation hit a 19-year high of 3.9% in January, while the Canadian unemployment rate is at a 3-year low of 5.5%. The US is facing even higher inflation and even lower unemployment, but one major difference between the two nations is the degree of household sector debt loads. Canada’s household debt/income ratio now stands at 180%, 55 percentage points higher than the equivalent US ratio, thanks to greater residential mortgage borrowing in Canada (Chart 6). Chart 5Stay Positioned For More UST-Bund Spread Widening Stay Positioned For More UST-Bund Spread Widening Stay Positioned For More UST-Bund Spread Widening The Canadian OIS curve is now discounting a peak policy rate of 3.1% in 2023, which is at the high end of the BoC’s estimated 1.75-2.75% range for the neutral policy rate. Chart 6The BoC Will Have Trouble Matching Fed Hawkishness The BoC Will Have Trouble Matching Fed Hawkishness The BoC Will Have Trouble Matching Fed Hawkishness ​​​​​ Elevated household debt will limit the BoC’s ability to lift rates that high, as this would trigger a major retrenchment of housing demand and a significant cooling of house prices. While the US is also facing issues with robust housing demand and high house prices, this is less of a factor that would limit Fed tightening relative to the BoC because US household balance sheets are not as levered as their Canadian counterparts. We are keeping our short US/long Canada spread trade (implemented using bond futures) in our Tactical Overlay portfolio, with the BoC unlikely to keep pace with the expected Fed rate increases over the next year (Chart 7). Chart 7Stay Positioned For A Narrower Canada-US Spread Stay Positioned For A Narrower Canada-US Spread Stay Positioned For A Narrower Canada-US Spread 10-year US Treasury-New Zealand government bond spread The third cross-country trade in our Tactical Overlay is 10-year New Zealand-US spread widening trade. Chart 8A Big Gap In NZ-US Relative Interest Rate Expectations A Big Gap In NZ-US Relative Interest Rate Expectations A Big Gap In NZ-US Relative Interest Rate Expectations ​​​​​​ Like the Germany and Canada spread trades, we expect the Fed to deliver more rate hikes than the Reserve Bank of New Zealand (RBNZ) which should push up US Treasury yields versus New Zealand equivalents. In the case of this trade, however, interest rate expectations in New Zealand are far more aggressive. Chart 9Stay Positioned For NZ-US Spread Tightening Stay Positioned For NZ-US Spread Tightening Stay Positioned For NZ-US Spread Tightening The RBNZ has already lifted its Official Cash Rate (OCR) by 75bps since starting the tightening cycle in mid-2021. The New Zealand OIS curve is now discounting an additional 253bps of rate hikes in this cycle, eventually reaching a peak OCR of 3.5% in June 2023. This would put the OCR into slightly restrictive territory based on the range of neutral rate estimates from the RBNZ’s various quantitative models (Chart 8). This contrasts to the pricing in the US OIS curve that places the peak in the fed funds rate at 2.8% next year before falling back to the low end of the FOMC’s 2.0-3.0% range of neutral estimates in 2024. Both the US and New Zealand are suffering from similarly high rates of inflation, with New Zealand headline inflation reaching 5.9% in the last available data from Q4/2021. However, while markets are already pricing in restrictive monetary settings in New Zealand, markets are yet to price in a similarly restrictive move in the fed funds rate. We continue to see scope for a narrowing of the New Zealand-US 10-year bond yield spread over at least the next six months. There has already been meaningful compression of the 2-year yield spread as US rate expectations have converged towards New Zealand levels (Chart 9) – we expect the 10-year spread to follow suit. Inflation Breakeven Trades: Swap Canada For Australia We currently have one inflation-linked bond (ILB) trade in our Tactical Overlay portfolio, betting on higher inflation breakevens in Australia. We initiated this trade last October, largely based on the signal from our suite of Comprehensive Breakeven Indicators (CBI) for the major developed economy ILB markets. The CBIs contain three components: the deviation from fair value from our 10-year breakeven spread models, the distance between realized headline inflation and the central bank target, and the gap between the 10-year breakeven and survey-based measures of longer-term inflation expectations. Those three measures are standardized and aggregated to form the CBI. Countries with lower CBIs have more upside potential for breakevens, and their ILBs should be favored over those from nations with higher CBIs. Chart 10Breaking Down Our Comprehensive Breakeven Inflation Indicators A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Chart 11Favor Canadian Inflation-Linked Bonds Vs. Australia Favor Canadian Inflation-Linked Bonds Vs. Australia Favor Canadian Inflation-Linked Bonds Vs. Australia Given the latest run-up in global inflation breakevens on the back of soaring oil prices, there are now no countries in our CBI universe that have a negative CBI (Chart 10). Canada has the lowest CBI, and thus the highest upside potential for breakeven spread widening. We are taking a modest profit of +40bps in our Australian breakeven trade, as we are approaching the self-imposed six-month holding period limit on our tactical trades and our Australian CBI is not indicating major upside for Australian breakevens.2 Based on the message from our indicators, we see a better case for entering a new tactical spread widening position in 10-year Canadian ILBs. A comparison of the CBIs between Canada and Australia shows that the Canadian 10-year inflation breakeven is well below our model-implied fair value, which incorporates both oil prices and currency levels (Chart 11). This contrasts to the Australian breakeven which is now well above fair value. A similar divergence appears when comparing breakeven spreads to survey-based measures of inflation expectations, with Canadian breakevens looking too “undervalued” compared to Australia. While realized headline inflation is above the respective central bank targets, especially in Canada, the valuation cushion makes the ILBs of the latter the better bargain of the two. The details of our new Canadian 10-year breakeven trade, where we go long the cash ILB and sell 10-year Canadian bond futures against it, are shown in our Tactical Overlay table on page 15.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The Treasury curve trade is actually a “butterfly” trade, where we have included an allocation to US 3-month Treasury bills (cash) to make the curve steepener duration-neutral. Thus, the trade is more specifically a position where we are long a 2-year US Treasury bullet and short a cash/10-year US Treasury barbell with a duration equal to that of the 2-year. 2     We have recently discovered an error in our how we have calculated the returns on the 10-year Australian futures leg of our Australian 10-year inflation breakeven widening trade. The final total return for our trade shown in the Tactical Overlay table on page 15 corrects for our error, and fortunately shows a significantly higher return than we have published in past reports. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Post-Invasion Reassessment Of Our Tactical Trade Recommendations A Post-Invasion Reassessment Of Our Tactical Trade Recommendations Tactical Overlay Trades

Executive Summary An inverted yield curve is a reliable recession indicator. Inversions of the 3-month/10-year Treasury slope and the 3-month/3-month, 18-months forward slope both provide more timely recession signals than inversion of the 2-year/10-year Treasury slope. An inverted yield curve is a reliable equity bear market indicator. Even when it’s not signaling a recession, the yield curve’s movements offer some insight into equity returns as stocks have consistently performed better while it is flattening than they have when it is steepening. The 2-year/10-year Treasury slope embeds useful information for corporate bond excess returns. Corporates perform best when the slope is very steep and worst when it is very flat and/or inverted. Treasury securities generally outperform cash when the yield curve is either very steep or inverted. The one exception is the early-1980s when the Fed continued to tighten aggressively even after an inversion of the yield curve. Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Bottom Line: The overall message from the yield curve is that, while the economic recovery is no longer in its early stages, it is premature to talk about a recession. On a 6-to-12 month investment horizon, investors should overweight equities in multi-asset portfolios. Within US bond portfolios, investors should maintain a neutral allocation to investment grade corporate bonds and keep portfolio duration close to benchmark. Feature It’s a well-known maxim in macro-finance that an inverted yield curve signals a recession. While that adage embeds a lot of truth, it is also sufficiently vague that it raises more questions than it answers. How far in advance does an inverted yield curve signal a recession? What specific yield curve segment sends the most helpful signal? And most importantly, does the yield curve tell us anything useful about the future performance of financial assets? These sorts of questions are particularly relevant today as we observe some sections of the yield curve approaching inversion while others make new highs (Chart 1). Chart 1Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals Different Slopes Are Sending Different Signals This Special Report explains how to think about the slope of the US Treasury curve as an indicator for the economy and financial markets. We first examine the yield curve’s empirical track record as a recession indicator. We then consider what the slope of the yield curve tells us about future equity, corporate bond and Treasury returns. The analysis presented in this report focuses on three different measures of the yield curve slope: The 2-year/10-year Treasury slope, the 3-month/10-year Treasury slope and the spread between the 3-month T-bill rate and the 3-month T-bill rate, 18 months forward. That last spread measure is less commonly cited, but Fed research has shown it to be a reliable predictor of recession.1 It was also recently highlighted by Fed Chair Jerome Powell.2 In the remainder of this report we will refer to the 3-month/3-month, 18-month forward spread as the “Fed Slope”. The Yield Curve & Recession Recession forecasting is a tricky business. It is often not so much a question of identifying “good” and “bad” recession indicators, but a question of balancing lead time and reliability. Recession indicators derived from financial market prices tend to offer greater advance warning of recession but also provide more false signals. On the flipside, indicators derived from macroeconomic data tend to give less lead time but with fewer false signals. Typically, the most useful recession indicators involve some combination of financial market and economic data. For example, a 2018 report from our US Investment Strategy service showed that a useful recession indicator can be created by combining the 3-month/10-year Treasury slope and the Conference Board’s Leading Economic Indicator.3 The Treasury slope’s reputation as an excellent recession indicator is justified because, despite it being derived from volatile financial market data, an inversion of the yield curve provides a very reliable recession signal. The 2-year/10-year Treasury slope has inverted in advance of 7 of the past 8 recessions and has not sent a false signal.4  The 3-month/10-year Treasury slope has done even better, calling 8 out of the past 8 recessions without a false signal. The Fed Slope, meanwhile, has also called 8 out of the past 8 recessions, but it sent one false signal in September 1998. There is room to quibble about the usefulness of the yield curve as a recession indicator in terms of lead time. The 2-year/10-year Treasury slope has, on average, inverted 15.9 months before the start of the next recession (Table 1). This inversion has always occurred before the first Fed rate cut of the cycle, and in all but one instance (1973-75), before the peak in the S&P 500. Table 1Lead Times For Yield Curve Segments, Equity Bear Markets And Fed Rate Cuts The Yield Curve As An Indicator The Yield Curve As An Indicator But while some advance warning is good, the 2-year/10-year slope probably gives too much lead time. For example, the 2-year/10-year slope inverted a full 24 months before the 2007-09 recession, but it would have been unwise to act on that information since the S&P 500 didn’t peak for another 22 months! The historical record shows that the 3-month/10-year Treasury curve and the Fed Slope offer more useful signals than the 2-year/10-year curve. On average, these curves provide less lead time than the 2-year/10-year slope but still generally provide advance warning of recession and stock market peaks. The recession signal from the 3-month/10-year slope has only missed the peak in the S&P 500 twice. The signal from the Fed Slope has only missed the stock market’s peak once, but it also sent one false signal. Synthesizing all this information, we conclude that the 3-month/10-year Treasury curve and the Fed Slope are both highly reliable recession indicators that typically provide more than enough advance warning for equity investors to adjust their positions. The main value of the 2-year/10-year Treasury curve is that its inversion warns that we may soon get a timelier signal from the 3-month/10-year Treasury slope and the Fed Slope. Looking at the present situation, the 2-year/10-year Treasury slope has flattened dramatically during the past few months, but at 18 bps it remains un-inverted. Meanwhile, the 3-month/10-year Treasury slope and the Fed Slope are both elevated at 195 bps and 255 bps, respectively. We can conclude from this that recession warnings are premature. We will become more concerned about an upcoming recession when the 3-month/10-year slope and the Fed Slope approach inversion. The Yield Curve & Equity Returns Identifying a recession and demarcating its beginning and ending dates may seem like a trivial exercise that has little practical import. Celebrated mutual fund manager Peter Lynch has repeatedly offered the opinion that any time an equity investor spends thinking about the economy is wasted time. We beg to differ. Equity bear markets reliably coincide with recessions (Chart 2) – since the late 1960s, only one recession has occurred without a bear market (the first leg of the Volcker double dip from January to July 1980) and only one bear market has occurred without a recession (October 1987’s Black Monday bear market) – and an asset allocator who reduced equity exposure upon receiving advance notice of recessions would have been in a position to generate significant alpha. Chart 2Recessions And Bear Markets Tend To Coincide Recessions And Bear Markets Tend To Coincide Recessions And Bear Markets Tend To Coincide The relationship between equity returns and the business cycle is not happenstance – variation in stock prices correlates closely with variation in corporate earnings and corporate earnings growth is a function of the business cycle. Equity prices, P, are simply the product of earnings per share, E, and the multiple investors are willing to pay for them, P/E: P = E x (P/E). If we hold somewhat fickle P/E multiples constant, stock prices will rise and fall with earnings. Given that earnings rarely decline outside of recessions (Chart 3), investors can expect equities to rise during expansions and decline during recessions. Chart 3Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Earnings Grow In Expansions And Fall In Recessions Earnings Declines Outside Of Recessions Are Rare Digging a little more deeply into the empirical record since consensus S&P 500 earnings estimates began to be compiled reinforces the earnings/returns link. With the exception of the first leg of the Volcker double dip recession in 1980, forward four-quarter earnings estimates have fallen in every recession and have contracted in the aggregate at an annualized 16% rate (Table 2). Multiples have expanded at a hearty 9% clip from the beginning to the end of recessions but have always declined, sometimes sharply, during them. Conversely, earnings estimates always grow heartily during expansions, while multiples tend to observe a fairly tight range. Multiples and stocks move ahead of the business cycle, consistently troughing before the end of a recession, but the 20-percentage-point expansion/recession disparity in annualized returns testifies to the yield curve’s utility as an investment leading indicator. Table 2When Earnings Fall, So Do Stocks The Yield Curve As An Indicator The Yield Curve As An Indicator The yield curve’s usefulness as a predictor of equity returns goes beyond recession signaling. Over the last half-century, the yield curve has tended to steepen and flatten in distinct phases. Defining a phase as a move of at least 200 basis points (bps) between the 3-month/10-year curve slope’s peak and trough, we count ten steepenings and nine flattenings since August 1969 (Chart 4). Chart 450 Years Of Steepening And Flattening 50 Years Of Steepening And Flattening 50 Years Of Steepening And Flattening After segmenting performance by slope increments in steepening (Table 3, top panel) and flattening (Table 3, middle panel) phases, we find a clear distinction. S&P 500 total returns tend to be much stronger when the yield curve is in a flattening phase than when it is steepening. In general, a steeper curve is better than a flatter (or inverted) one for equity returns but flattening dominates steepening in every segment but the current one (150-200 bps). The cheery news for investors concerned about an inverted yield curve’s effect on stocks is that the upcoming flattening increments between now and inversion have historically been favorable. Though we are tactically neutral equities, we recommend overweighting them in multi-asset portfolios over a cyclical 6-to-12 month timeframe. Table 3Stocks Like A Flattening Yield Curve The Yield Curve As An Indicator The Yield Curve As An Indicator The Yield Curve & Corporate Bond Returns This section of the report considers investment grade corporate bond returns in excess of a duration-matched position in US Treasuries and whether the slope of the Treasury curve can help us predict their magnitude. First, it’s important to point out that there is a lot of overlap between excess corporate bond returns and equity returns, but it is not complete (Chart 5). Corporates certainly tend to underperform duration-matched Treasuries during recessions and equity bear markets, but there have also been significant bouts of underperformance that fall outside of those periods. For example, corporate bond returns peaked well before equity returns in the late-1990s and corporates also underwent a severe selloff in 2014-15. Chart 5Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend That said, Table 4 shows that, as is the case with stocks, a strategy of reducing corporate bond exposure during recessions will profit over time. Corporate bonds have underperformed Treasuries by a cumulative 3.1% (annualized) during recessions since 1979 and have outperformed by 1.2% (annualized) in non-recessionary periods. Table 4Corporate Bond Performance In And Out Of Recessions The Yield Curve As An Indicator The Yield Curve As An Indicator The results in Table 4 suggest that investors should remain overweight corporate bonds versus Treasuries at least until the 3-month/10-year Treasury slope inverts. However, we think investors can perform even better if they pay attention to early warning signs from the 2-year/10-year Treasury slope. Table 5 shows historic 12-month corporate bond excess returns given different starting points for the 2-year/10-year slope. The starting points are also split depending on whether the 2-year/10-year slope was in a steepening or flattening trend at the time. Table 512-Month Investment Grade (IG) Corporate Bond Returns By Starting Slope Level And Trend The Yield Curve As An Indicator The Yield Curve As An Indicator The results presented in Table 5 show that the level of the slope matters much more than whether the curve is in a steepening or flattening trend. They also show that, in general, excess returns tend to be much higher when the slope is steep than when it is flat. We also see that the odds of corporate bonds outperforming duration-matched Treasuries on a 12-month horizon decline markedly for periods when the 2-year/10-year slope starts below 25 bps. At present, the 2-year/10-year Treasury slope is 18 bps, just below the 25-bps cutoff. Though we take this negative signal from the yield curve seriously, we also anticipate that peaking inflation will prevent the Fed from raising rates by 245 bps during the next 12 months, the pace that is currently discounted in the yield curve. If this view pans out it will likely lead to some modest 2/10 curve steepening and a relief rally in corporate spreads. To square the difference between the current negative message from the yield curve and our more optimistic macro view, we recommend a neutral allocation to investment grade corporate bonds within US fixed income portfolios. Though we will likely downgrade our recommended allocation if the 2-year/10-year slope continues to flatten and approaches inversion. The Yield Curve & Treasury Returns This section of the report considers US Treasury index returns in excess of a position in cash, a metric designed to proxy for the returns earned by varying a US bond portfolio’s average duration. Treasury outperformance of cash indicates that long duration positions are profiting while Treasury underperformance of cash indicates that short duration positions are in the green. The historical relationship between Treasury returns and the slope of the yield curve is heavily influenced by the early-1980s period when the Fed plunged the economy into a double-dip recession to contain spiraling inflation. Chart 6 shows that this early-1980s episode is the only one where Treasuries sold off steeply even after all three of our yield curves had inverted. Chart 6A Repeat Of The Early 1980s Episode Remains Unlikely A Repeat Of The Early 1980s Episode Remains Unlikely A Repeat Of The Early 1980s Episode Remains Unlikely In fact, if we look at the history of 12-month Treasury returns going back to 1973 split by the starting point for the slope (Tables 6A, 6B & 6C), we see that returns are worst after the curve is inverted and best when the curve is very steep. Table 6A12-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Slope Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 6B12-Month Treasury Excess Returns* Given Different Starting Points For 3-Month / 10-Year Slope Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 6C12-Month Treasury Excess Returns* Given Different Starting Points For the Fed Slope** Since 1973 The Yield Curve As An Indicator The Yield Curve As An Indicator However, that picture changes if we start our historical sample in 1985 to exclude the early-1980s episode. Now, we see that Treasury returns tend to be high when the yield curve is very steep and when it is inverted (Tables 7A, 7B & 7C). The worst 12-month periods for Treasury returns are when the 2-year/10-year slope is between 75 bps and 100 bps, when the 3-month/10-year slope is between 50 bps and 75 bps and when the Fed Curve is between 0 bps and 25 bps. If we apply today’s situation to the post-1985 results shown in Tables 7A, 7B & 7C, we would conclude that the outlook for Treasury returns is very positive. The 3-month/10-year slope and Fed Curve are very steep, and the 2-year/10-year slope is in the 0 bps to 25 bps range. Of course, that message from the 2-year/10-year slope flips if viewed in the context of the post-1973 data shown in Table 6A. Table 7A12-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Slope Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 7B12-Month Treasury Excess Returns* Given Different Starting Points For 3-Month / 10-Year Slope Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Table 7C12-Month Treasury Excess Returns* Given Different Starting Points For the Fed Slope** Since 1985 The Yield Curve As An Indicator The Yield Curve As An Indicator Our assessment is that the risk of a repeat of the early-1980s episode is still relatively small. Yes, inflation is extremely high, but it is likely to moderate naturally as we gain more distance from the pandemic. In that environment, the Fed will not feel the need to continue tightening aggressively even after all three segments of the yield curve have inverted. As such, we are inclined to view the message from the yield curve as positive for Treasury returns on a 12-month horizon, and we continue to advocate keeping average bond portfolio duration “at benchmark”.   Ryan Swift US Bond Strategist rswift@bcaresearch.com   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-20180628.htm 2 https://www.bloomberg.com/news/articles/2022-03-21/powell-says-look-at-short-term-yield-curve-for-recession-risk?sref=Ij5V3tFi 3 Please see US Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?”, dated August 13, 2018. 4 We define an instance of “inversion” as a yield curve slope below zero for two consecutive months. Treasury Index Returns Spread Product Returns

Executive Summary Expansion In European Defense Expanding Military Spending Expanding Military Spending European yields have significant upside on a structural basis. European government spending will remain generous, which will boost domestic demand; meanwhile, lower global excess savings will lift the neutral rate of interest and structurally higher inflation will boost term premia. A short-term pullback in yields is nonetheless likely; however, it will not short-circuit the trend toward higher yields on a long-term basis. CYCLICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Favor European Aerospace & Defense Over European Benchmark 3/28/2022     Favor European Aerospace & Defense Over Other Industrials 3/28/2022     Bottom Line: Investors should maintain a below-benchmark duration in their European fixed-income portfolios. Higher yields driven by robust domestic demand and strong capex also boost the appeal of industrial, materials, and financials sectors. Aerospace and defense stocks are particularly appealing.     The economic impact of the war in Ukraine continues to drive the day-to-day fluctuations of the market; however, investors cannot ignore the long-term trends in the economy and markets. The direction of bond yields over the coming years is paramount among those questions. Does the recent rise in yields only reflect the current inflationary shock caused by both supply-chain impairments and commodity inflation—that is, is it finite? Or does that rise mirror structural forces and therefore have much further to run? We lean toward yields having more upside over the coming years, propelled higher by structural forces. As a result, we continue to recommend investors structurally overweight sectors that benefit from a rising yield environment, such as financials and industrials, while also favoring value over growth stocks. The defense sector is particularly attractive. Three Structural Forces Behind Higher Yields The current supply-chain disruptions and inflation crises have played a critical role in lifting European yields. However, a broader set of factors underpins our bearish bond view—namely, the lack of fiscal discipline accentuated by the consequences of the Ukrainian war, the likely move higher in the neutral rate of interest generated by lower savings, and the long-term uptrend in inflation. Profligate Governments Chart 1 The Lasting Bond Bear Market The Lasting Bond Bear Market Larger government deficits will contribute to higher European yields. Europe is not as fiscally conservative as it was before the COVID-19 crisis. Establishment politicians must fend off pressures caused by voters attracted to populist parties willing to spend more. Consequently, IMF estimates published prior to the Ukrainian war already tabulated that, for the next five years, Europe’s average structurally-adjusted budget deficit would be 2.4% of GDP wider than it was last decade (Chart 1). Chart 2Expanding Military Spending Expanding Military Spending Expanding Military Spending The Ukrainian crisis is also prompting a fiscal response that will last many years. Europe does not want to stand still in the face of the Russian threat. Today, Western Europe’s military spending amounts to 1.5% of GDP, or €170 billion. This is below NATO’s threshold of 2% of GDP. Rebuilding military capacity will take large investments. Thus, European nations are likely to move toward that target and even go beyond. Conservatively, if we assume that military spending hits 2% of GDP by the end of the decade, it will rise above €300 billion (Chart 2). Weaning Europe off Russian energy will also prevent a significant fiscal retrenchment. This effort will take two dimensions. The first initiative will be to build infrastructures to receive more LNG from the rest of the world to limit Russian intake. Constructing regasification and storage facilities as well as re-directing pipeline networks be costly and require additional CAPEX over the coming years. The second initiative will be to double-up on green initiatives to decrease the need for fossil fuel. The NGEU funds are already tackling this strategic goal. Nonetheless, the more than €100 billion reserved for renewable energy and energy preservation initiatives was only designed to kick-start hitting the EU’s CO2 emission target for 2050. Accelerating this process not only helps cutting the dependence on Russian energy, but it is also popular with voters. The path of least resistance is to invest in that sphere and to increase such investment beyond the current sums from the NGEU program. The last fiscal push is likely to be more temporary. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. Accommodating that many individuals will be costly and will add to government spending across the region. Even if mostly transitory, this spending will have an important impact on activity. Larger fiscal deficits push yields higher for two reasons. Greater sovereign issuance that does not reflect a negative shock to the private sector will need to offer higher rates of returns to attract investors. Moreover, greater government spending will boost aggregate demand, which increases money demand. As a result, the price of money will be higher than otherwise, which means that interest rates will rise—as will yields. Decreasing Global Excess Savings Decreasing global excess savings will put upward pressure on the global neutral rate of interest, a phenomenon Peter Berezin recently discussed in BCA’s Global Investment Strategy service. This process will be visible in Europe as well. The US will play an important role in the process of lifting global neutral rates because the dollar remains the foundation of the global financial system. Compared to last decade, the main drag on US savings is that household deleveraging is over. As households decreased their debt load following the global financial crisis, a large absorber of global savings vanished, putting downward pressure on the price of those savings. Today, US households enjoy strong net worth equal to 620% of GDP and have resumed accumulating debt (Chart 3). Consequently, the downward trend in US total private nonfinancial debt loads has ended. The US capex cycle is likely to experience a boost as well. As Peter highlighted, the US capital stock is ageing (Chart 4). Moreover, the past five years have witnessed three events that underscore the fragility of global supply-chains: a disruptive Sino-US trade war, a pandemic, and now a military conflict. This realization is causing firms to move from a “just-in-time” approach to managing supply-chains to a “just-in-case” one. The process of building redundancies and localized supply chains will add to capex for many years, pushing up ex-ante investments relative to savings, and thus, interest rates. Chart 3US Households Are Done Deleveraging US Households Are Done Deleveraging US Households Are Done Deleveraging Chart 4An Ageing US Capital Stock An Ageing US Capital Stock An Ageing US Capital Stock China’s current account surplus is also likely to decline. For the past two decades, China has been one of the largest providers of savings to the global economy. This is a result of an annual current account surplus that first averaged $150 billion per year from 2000 to 2010 and then $180 billion from 2010 to 2020, and now stands at $316 billion. Looking ahead, China wants to use fiscal policy more aggressively to support demand, which often boosts imports without increasing exports. Also, more domestically-oriented supply chains around the world will limit the growth of Chinese exports. This combination will compress Chinese excess savings, which will place upward pressure on the global neutral rate of interest. Europe is not immune to declining savings. Over the past ten years, the Euro Area current account surplus has averaged €253 billion. Germany’s current account surplus stood at 7.4% of GDP before the pandemic. Those excess savings depressed global rates in general and European ones especially (Chart 5). As in the US, Europe’s capital stock is ageing and needs some upgrade (Chart 6). Moreover, greater government spending boosts aggregate demand. Because investment is a form of derived demand, stronger overall spending promotes capex to a greater extent. Thus, Europe’s public infrastructure push will lift private capex and curtail regional excess savings beyond the original drag from wider fiscal deficits. Additionally, the European population is getting older and will have to tap into their excess savings as they retire. This process will further diminish Europe’s current account surplus, that is, its excess savings. Chart 5Excess Savings Cap Relative Yields Excess Savings Cap Relative Yields Excess Savings Cap Relative Yields Chart 6An Ageing European Capital Stock Too An Ageing European Capital Stock Too An Ageing European Capital Stock Too Structurally Higher Inflation BCA believes that the current inflation surge is temporary and mostly reflects a mismatch between demand and supply. However, we also anticipate that, once this inflation climax dissipates, inflation will settle at a level higher than that prior to COVID-19 and will trend higher for the remainder of this decade. Labor markets will tighten going forward because policy rates remain well below neutral interest rates. Output gaps will close because of robust government spending and capex. This will keep wage growth elevated in the US and reanimate moribund salary gains in the Eurozone (Chart 7). This process, especially when combined with less efficient global supply chains and lower excess savings (which may also be thought of as deficient demand), will maintain inflation at a higher level than in the past two decades. Higher inflation will lift yields for two main reasons. First, investors will require both greater long-term inflation compensation and higher policy rates than in the past. Second, higher inflation often generates greater economic volatility and policy uncertainty, which means that today’s minimal term premia will increase over time (Chart 8). Together, these forces will create a lasting upward drift in yields. Chart 7European Wages Will Eventually Revive European Wages Will Eventually Revive European Wages Will Eventually Revive Chart 8Term Premia Won't Stay This Low Term Premia Won't Stay This Low Term Premia Won't Stay This Low Bottom Line: European yields will sport a structural uptrend for the remainder of the decade. Three forces support this assertion. First, European government spending will remain generous, supported by infrastructure and military spending. Second, global excess savings will recede as US consumer deleveraging ends, global capex rises, and the Chinese current account surplus narrows. Europe will mimic this process in response to an ageing population, greater government spending, and capex. Finally, inflation is on a structural uptrend, which will warrant higher term premia across the world. Not A Riskless View There are two main risks to this view, one in the near-term and one more structural. The near-term risk is the most pertinent for investors right now. Global yields may have embarked on a structural upward path, but a temporary pullback is becoming likely. As Chart 9 highlights, the expected twelve-month change in the US policy rate is at the upper limit of its range of the past three decades. Historically, when the discounter attains such a lofty level, a retrenchment in Treasury yields ensues, since investors have already discounted a significant degree of tightening. The same is true in Europe, where the ECB discounter is also consistent with a temporary pullback in German 10-year yields (Chart 10). Chart 9Discounters Point To A Treasury Rally... Discounters Point To A Treasury Rally... Discounters Point To A Treasury Rally... Chart 10... And A Bund Rally ... And A Bund Rally ... And A Bund Rally Chart 11A Mixed Message A Mixed Message A Mixed Message Investor positioning confirms the increasing tactical odds of a yield correction. The BCA Composite Technical Indicator for bonds is massively oversold, which often anticipates a bond rally (Chart 11). This echoes the signals from the JP Morgan surveys that highlight the very low portfolio duration of the bank’s clients. However, the BCA Bond Valuation Index suggests that bonds remain expensive. Together, these divergent messages point toward a temporary bond rally, not a permanent one. The longer-term risk is regularly highlighted by Dhaval Joshi in BCA’s Counterpoint service. Dhaval often shows that the stock of global real estate assets has hit $300 trillion or 330% of global GDP. Real estate is a highly levered asset class and global cap rates have collapsed with global bond yields. With little valuation cushion, real estate prices could become very vulnerable to higher yields. Nevertheless, real estate is also a real asset that produces an inflation hedge. Moreover, rental income follows global household income, and stronger aggregate demand will likely lift median household income especially in an environment in which globalization has reached its apex and populism remains a constant threat. Bottom Line: Global investor positioning has become stretched; therefore, a near-term pullback in yield is very likely, especially as central bank expectations have become aggressive. Nonetheless, a bond rally is unlikely to be durable in an environment in which bonds are expensive and in which growth and inflation will remain more robust than they were last decade. A greater long-term risk stems from expensive global real estate markets. However, real estate is sensitive to global economic activity and inflation, which should allow this asset class ultimately to weather higher yields. Investment Conclusions An environment in which yields rise will inflict additional damage on global bond portfolios. This is especially true in inflation-adjusted terms, since real yields stand at a paltry -0.76% in the US and -2.5% in Germany. Hence, we continue to recommend investors maintain a structural below-benchmark duration bias in their portfolios. Nonetheless, investors with enough flexibility in their investment mandate should take advantage of the expected near-term pullback in yields. Those without this flexibility should use the pullback as an opportunity to shorten their portfolio duration. Higher yields will also prevent strong multiple expansion from taking place; hence, the broad stock market will also offer paltry long-term real returns. Another implication of rising yields, especially if they reflect stronger growth and rising neutral interest rates, is to underweight growth stocks relative to value stocks (Chart 12). Growth stocks are expensive and very vulnerable to the pull on discount rates that follows rising risk-free rates. Meanwhile, stronger economic activity driven by infrastructure spending and capex will help the bottom line of industrial and material firms. Financials will also benefit. Higher yields help this sector and robust capex also boosts loan growth, which will generate a significant tailwind for banking revenues. Hence, rising yields will boost the attractiveness of banks, especially after they have become significantly cheaper because of the Ukrainian war (Chart 13). Chart 12Favor Value Over Growth Favor Value Over Growth Favor Value Over Growth Chart 13Bank Remain Attractive Bank Remain Attractive Bank Remain Attractive Related Report  European Investment StrategyFallout From Ukraine Finally, four weeks ago, we highlighted that defense stocks were particularly appealing in today’s context. The re-armament of Europe in response to secular tensions with Russia is an obvious tailwind for this sector. However, it is not the only one. A long-term theme of BCA’s Geopolitical Strategy service is the expanding multipolarity of the world.  The end of an era dominated by a single hegemon (the US) causes a rise in geopolitical instability and tensions. The resulting increase in conflict will invite a pickup in global military spending. Chart 14Defense Will Outshine The Rest Defense Will Outshine The Rest Defense Will Outshine The Rest European defense and aerospace stocks are expensive, with a forward P/E ratio approaching the top-end of their range relative to the broad market and other industrials. However, their relative earnings are also depressed following the collapse in airplane sales caused by the pandemic. Our bet on the sector is that its earnings will outperform the broad market as well as other industrials because of the global trend toward military buildup. As relative earnings recover their pandemic-induced swoon, so will relative equity prices (Chart 14). Bottom Line: Higher yields warrant a structural below-benchmark duration in European fixed-income portfolios, even if a near-term yield pullback is likely. As a corollary, value stocks will outperform growth stocks while industrials, materials, and financials will also beat a broad market whose long-term real returns will be poor. Within the industrial complex, aerospace and defense equities are particularly appealing because a global military buildup will boost their earnings prospects durably.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Due to travel commitments, there will be no Counterpoint report next week. Instead, we will send you a timely update and analysis of the Ukraine Crisis written by my colleague Matt Gertken, BCA Chief Geopolitical Strategist. Executive Summary The tight connection between the oil price and inflation expectations is intuitive, appealing… and wrong. The inflation market is tiny, and its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare, such as that which follows an oil price spike. Hence, we should treat inflation expectations and the real bond yield that is derived from them with extreme care – especially after an oil price spike, which will give the illusion that the real bond yield is lower than it really is. In the near term, the Ukraine crisis has added to already elevated fears about inflation, which will pressure both bonds and stocks. However, looking beyond the next few months, the Ukraine crisis triggered supply shock will cause demand destruction, while central banks also choke demand, and the recent massive displacement of demand into goods, and its associated inflationary impulse, reverses. The 12-month asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Fractal trading watchlist: The sell-off in some T-bonds is approaching capitulation. The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive,Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive,Appealing... And Wrong Bottom Line: In the near term, an inflationary impulse will dominate, but on a 12-month horizon, a disinflationary impulse will dominate. Feature In his seminal work Thinking Fast And Slow, Nobel Laureate psychologist Daniel Kahneman presented the bat-and-ball puzzle. A bat and ball cost $1.10. The bat costs one dollar more than the ball. How much does the ball cost? “A number came to your mind. The number, of course, is 10: 10 cents. The distinctive mark of this easy puzzle is that it evokes an answer that is intuitive, appealing, and wrong. Do the math, and you will see. If the ball costs 10 cents, then the total cost will be $1.20 (10 cents for the ball and $1.10 for the bat), not $1.10. The correct answer is 5 cents. It is safe to assume that the intuitive answer also came to the mind of those who ended up with the correct number – they somehow managed to resist the intuition.” Kahneman’s crucial finding is that many people are prone to place too much faith in an intuitive answer, an intuitive answer that they could have rejected with a small investment of effort. The Connection Between The Oil Price and Inflation Expectations Is Intuitive, Appealing… And Wrong Today, the financial markets are presenting their very own bat-and-ball puzzle. The surging price of crude oil is driving up the market expectation for inflation over the next ten years (Chart I-1). This tight relationship is intuitive and appealing, because we associate a high oil price with a high inflation rate. But the intuitive and appealing relationship is wrong, and it requires just a small investment of effort to prove the fallacy. Chart I-1The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong Inflation over the next ten years equals the price in ten years’ time divided by the current price. So, to the extent that there is any relationship between the current price and expected inflation, dividing by a higher price today means a lower prospective inflation rate. Empirically, the last fifty years of evidence confirms this very clear inverse relationship (Chart I-2). Chart I-2A High Oil Price Means Lower Subsequent Inflation A High Oil Price Means Lower Subsequent Inflation A High Oil Price Means Lower Subsequent Inflation This raises an obvious question: while many people accept the intuitive (wrong) relationship between the oil price and expected inflation, how can the market make such a glaring error? The answer is that the inflation market is relatively tiny, and that its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare. Compared to the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion, slightly more than the market capitalisation of Tesla. Just as we do not expect Tesla to represent the view of the entire stock market, we should not expect TIPS to represent the view of the entire bond market. A high oil price means lower subsequent inflation. A recent paper by The Oxford Institute For Energy Studies explains: “the tight relationship between the oil price and inflation expectations defies not only the thesis of economics, but the norms of statistics as well, with a correlation that has reached 90 percent over the last ten years and a corresponding r-squared of 82 percent (Chart I-3 and Chart I-4). The root cause of this phenomenon should probably be searched for in the behaviour of another large group of market participants, the systematic portfolio allocators, and factor investors.”1  Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Chart I-4...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price ...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price ...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price So, here’s the explanation for the intuitive, appealing, but wrong connection between the oil price and inflation expectations. In the inflation scare that a surging oil price unleashes, the two main asset-classes – bonds and equities – are vulnerable to sharp losses, leaving TIPS as one of the very few assets that can provide a genuine hedge against inflation. But given that bonds and equities dwarf the $1.5 trillion TIPS (and other inflation) markets, the inflation hedger quickly becomes the dominant force in this tiny market. This large volume of hedging demand chasing limited supply drives down the real yields on TIPS to artificial lows, both in absolute terms and relative to T-bond yields. And as the difference between nominal and real yields defines the ‘market’s expected inflation’, it explains the surge in expected inflation. Be Careful How You Use ‘The Real Bond Yield’ It is an unfortunate reality that we often close the stable door after the horse has bolted, meaning that we react after, rather than before, the event. In financial market terms, this means that we demand inflation protection after, rather than before, it happens, and end up overpaying for it. A high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. To repeat, a high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. The upshot is that the performance of TIPS versus T-bonds is nothing more than a play on the oil price (Chart I-5). Chart I-5The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price A bigger message is that we should interpret the oft-quoted ‘real bond yield’ with extreme care. The real bond yield is nothing more than the nominal bond yield less a mathematical function of the oil price. So, when the oil price is high, it will give the illusion that the real bond yield is low. The danger is that if we value equities against the real bond yield when the oil price is high – such as through 2011-14 or now – equities will appear cheaper than they really are (Chart I-6). Chart I-6When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities is versus the product of the nominal bond price and current profits. This valuation approach perfectly explains the US stock market’s evolution both over the long term (Chart I-7) and the short term. Specifically, over the past year, the dominant driver of the US stock market has been the 30-year T-bond price (Chart I-8). Chart I-7The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) Chart I-8The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) 12-Month Asset Allocation Conclusion The current inflation scare comes not from an aggregate demand shock, but from a massive displacement of demand (into goods) followed by the more recent supply shock for energy and food triggered by the Ukraine crisis. In response, central banks are trying to douse the inflation in the only way they can – by choking aggregate demand. Hence, there is a dangerous mismatch between the malady and the remedy. In the near term, the Ukraine crisis has added to already elevated fears about inflation – and this will pressure both bonds and stocks. However, looking beyond the next few months, the near-term inflationary impulse will unleash a disinflationary response from three sources. First, a supply shock means higher prices without stronger demand, which causes an inevitable demand destruction that then pulls down prices. Second, central banks are explicitly trying to pull down prices – or at least price inflation – by choking demand. And third, the massive displacement of demand into goods, and its associated inflationary impulse, is reversing. On a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. Therefore, on a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. The asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Is The Bond Sell-Off Close To Capitulation? Finally, several clients have asked if the recent sell-off in bonds is close to capitulation, based on the fragility of its fractal structures. The answer is yes, but only for the shorter maturity T-bonds. Specifically, the 5-year T-bond has reached the point of fragility on its composite 130-day/260-day fractal structure that marked the bottom of the sell-off in 2018, as well as the top of the rally in 2020 (Chart I-9). Chart I-9The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation Accordingly, this week’s trade recommendation is to buy the 5-year T-bond, setting the profit target and symmetrical stop-loss at 4 percent, and with a maximum holding period of 1 year. Please note that our full fractal trading watchlist is now available on our website:  cpt.bcaresearch.com     Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/08/Is-the-Oil-Price-Inflation-Relationship-Transitory.pdf Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal Chart 7The Euro’s Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 10Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Chart 11CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 12Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Chart 13Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 14Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Chart 15BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Fractal Trading System Fractal Trades Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Tracking Inflation In 2022 Tracking Inflation In 2022 Tracking Inflation In 2022 Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). A 50 bps rate hike is possible at some point this year, but only if long-maturity inflation expectations become un-anchored or core PCE inflation prints consistently above 0.30%-0.35% per month. Historical evidence suggests that Treasury securities perform best when the yield curve is very steep or very flat. All else equal, an inversion of the 2-year/10-year Treasury slope would make us more bullish on bonds. High-yield corporates have performed better than investment grade corporates during the recent sell-off. Investors should continue to favor high-yield corporates over investment grade. Bottom Line: Investors should maintain “at benchmark” portfolio duration and buy Treasury curve steepeners. We also maintain an overweight allocation to high-yield corporate bonds and a neutral allocation to investment grade corporates. We Have Liftoff The Fed followed through on its earlier promise and lifted the funds rate by 25 basis points last week. FOMC participants also sharply revised up their expectations for the future pace of tightening, though this revision mostly just made the Fed’s forecast more consistent with what was already priced in the yield curve. Market rate hike expectations, as inferred from the overnight index swap curve, shifted up only slightly after the Fed’s announcement (Chart 1). Chart 1Rate Expectations Rate Expectations Rate Expectations As of Monday morning, the bond market is priced for 208 bps of tightening during the next 12 months and 174 bps between now and the end of the year. This is close to the median FOMC forecast which calls for 150 bps of further tightening this year followed by an additional 92 bps in 2023. Last week’s report highlighted the tricky situation faced by the Fed.1 On the one hand, the Fed must tighten quickly enough to keep long-dated inflation expectations anchored. On the other hand, the Fed wants to avoid tightening so quickly that it causes a recession. For investors, we think it makes sense to assume that the Fed will try to split the difference by lifting rates at a pace of 25 bps per meeting for at least the next 12 months. However, there are significant risks to both the upside and downside of this projection. The Odds Of A 50 bps Hike The upside risk is that inflation is sufficiently sticky that the Fed will feel the need to deliver a 50 bps rate hike at some point this year. Last week’s Fed interest rate projections show that 7 out of 16 FOMC participants think that at least one 50 bps rate hike will be necessary. Meanwhile, market prices are consistent with one 50 basis point rate hike and five 25 basis point rate hikes at this year’s six remaining FOMC meetings. We think the Fed will only deliver a 50 bps rate hike if inflation looks to be tracking above the committee’s 2022 forecast or if long-maturity inflation expectations become un-anchored to the upside. Related Report  Global Investment StrategyIs A Higher Neutral Rate Good Or Bad For Stocks? On the inflation front, the FOMC’s central tendency forecast calls for core PCE inflation of between 3.9% and 4.4% in 2022, with a median of 4.1%. To match this forecast, core PCE will have to average a monthly growth rate of between 0.30% and 0.35% in each of this year’s eleven remaining months (Chart 2).2 Every monthly inflation print above that range increases the odds of a 50 bps Fed move, every print below that range brings the odds down. As for long-maturity inflation expectations, the Fed likely views them as “well anchored” for the time being. The 10-year TIPS breakeven inflation rate has broken meaningfully above the Fed’s target range but the 5-year/5-year forward TIPS breakeven inflation rate remains consistent with the Fed’s goals (Chart 3). The University of Michigan’s survey measure of 5-10 year household inflation expectations has risen sharply, but it has not yet broken meaningfully above recent historical levels (Chart 3, bottom panel). Chart 2Tracking Inflation In 2022 Tracking Inflation In 2022 Tracking Inflation In 2022 Chart 3Inflation Expectations Inflation Expectations Inflation Expectations Our sense is that inflation is very close to peaking and that lower inflation in the back half of the year will apply downward pressure to inflation expectations and prevent the Fed from delivering a 50 bps hike at any single FOMC meeting. However, we will be closely tracking the evolution of Charts 2 and 3 to see if this situation changes. The Odds Of Skipping A Meeting Chart 4Financial Conditions Financial Conditions Financial Conditions The downside risk to the Fed’s expected rate hike path results from the fact that financial conditions have already responded aggressively to the Fed’s actions and communications. While it’s certainly true that financial conditions remain extremely accommodative in level terms (Chart 4), we must also acknowledge that, historically, the sort of rapid tightening of financial conditions that we have already seen is almost always followed by a significant slowdown in economic activity (Chart 4, panel 2). On top of all that, the yield curve is now completely flat beyond the 5-year maturity point and the 2-year/10-year Treasury slope is a mere 22 bps away from inversion (Chart 4, bottom panel). The Fed’s new interest rate projections show the median expected interest rate moving above estimates of the long-run neutral rate in 2023 and 2024. This sort of rate hike path is consistent with a mild inversion of the yield curve, and the Fed will likely downplay the yield curve’s recession signal during the next few months. That said, a deepening inversion of the yield curve will only increase market worries about an over-tightening of monetary policy. This could lead to a sell-off in risk assets that would accelerate the tightening of financial conditions and lead to expectations of even slower economic growth. The next section of this report explores what an inverted 2-year/10-year yield curve has historically meant for Treasury returns. Investment Implications Our base case view is that inflation will moderate in the coming months, allowing the Fed to deliver a steady pace of tightening (25 bps per meeting). We also see economic growth slowing but remaining solid enough to prevent a significant sell-off in risk assets and a deep inversion of the yield curve. We also acknowledge, however, that the risks to this view (in both directions) are unusually high. Given all that, our recommended investment strategy is to keep portfolio duration close to benchmark. The market is already well priced for a steady 25 bps per meeting pace of tightening and bond yields will merely keep pace with forwards if that pace is delivered. We also see yield curve steepeners profiting during the next 6-12 months as the yield curve’s flattening trend takes a pause now that market expectations have fully adjusted to the likely path of Fed rate increases. We remain neutral TIPS versus nominal Treasuries at the long-end of the curve, but underweight TIPS versus nominal Treasuries at the front-end. Short-maturity TIPS will underperform as inflation moderates in H2 2022. The Yield Curve And Treasury Returns The historical relationship between the slope of the yield curve and Treasury returns is very interesting. To examine it, we first looked at historical data on excess Treasury index returns versus cash since 1989 (Table 1). Table 112-Month Treasury Excess Returns* Given Different Starting Points For 2-Year / 10-Year Treasury Slope The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Specifically, we show 12-month excess Treasury returns given different starting points for the 2-year/10-year Treasury slope. For example, when the 2-year/10-year Treasury slope has been between 0 bps and 25 bps, the Bloomberg Barclays Treasury Index has historically outperformed a position in cash by an average of 2.75% during the next 12 months. A 90% confidence interval places expected returns between 1.75% and 3.73%, and excess Treasury returns were positive in 73% of historical observations. The first big conclusion that jumps out from Table 1 is that Treasuries perform best when the yield curve is either very steep or very flat. The worst periods for Treasury returns have tended to occur when the slope is between 25 bps and 100 bps. It’s easy to understand why a very steep yield curve would lead to strong Treasury returns. A steep curve means that Treasuries offer a large yield advantage versus cash, or put differently, an extremely rapid pace of rate hikes would be necessary for cash returns to overcome the carry advantage in bonds. It’s more difficult to understand why Treasury returns have been strong after instances of curve inversion. The most likely reason is that market participants have tended to overestimate the odds of the Fed achieving a “soft landing” and have underestimated the odds of an upcoming recession and rate cuts. The data used in Table 1 are limited in that observations only begin in 1989. As such, the table misses the Paul Volcker period of the early 1980s when Treasuries continued to sell off well after the curve inverted. Chart 5 extends the historical period back to the mid-1970s and uses shading to indicate periods of 2-year/10-year yield curve inversion. Chart 5Yields Tend To Peak Shortly After Curve Inversion Yields Tend To Peak Shortly After Curve Inversion Yields Tend To Peak Shortly After Curve Inversion Chart 5 reveals a pretty clear pattern. With the exception of the late-1970s/early-1980s episode, the 10-year Treasury yield tends to peak right around the time of 2-year/10-year yield curve inversion, or shortly after in the case of 1989. What can we take away from this analysis? First, the evidence suggests that we should have a bias toward taking more duration risk in our portfolio if and when the yield curve inverts. A more deeply inverted yield curve should also be viewed as a stronger bond-bullish signal than a modestly inverted yield curve. Second, we must acknowledge the major risk to this strategy. Specifically, the risk that inflation will be so high that the Fed will continue to tighten aggressively even after the yield curve inverts, as Paul Volcker did in the early-1980s. Our sense is that the odds of a repeat “Volcker moment” are low. Inflation will naturally fall as the pandemic’s impact wanes and the Fed won’t be forced to deliver another hawkish shock to market expectations. Therefore, we maintain our “at benchmark” recommendation for portfolio duration for now, but we may turn more bullish on bonds if the yield curve inverts. The Poor Performance Of Investment Grade Bonds Chart 6IG Has Lagged HY IG Has Lagged HY IG Has Lagged HY One notable aspect of recent bond market moves has been that the performance of investment grade corporate bonds has significantly lagged the performance of high-yield corporate bonds during the recent period of spread widening (Chart 6). This is highly unusual. Typically, we expect bonds with more credit risk to behave like “higher beta” securities. That is, we expect lower-rated bonds to perform better in bull markets and worse in bear markets.3 The typical relationships held earlier in the cycle. Chart 7A shows that high-yield corporate bonds delivered stronger excess returns than investment grade corporate bonds from the March 2020 peak in spreads through the end of that year. Chart 7B shows that high-yield continued to outperform investment grade throughout the bull market for spreads in 2021. Chart 7ACorporate Bond Excess Returns* Versus DTS: March 2020 To December 2020 The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Chart 7BCorporate Bond Excess Returns* Versus DTS: January 2021 To September 2021 The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Chart 7CCorporate Bond Excess Returns* Versus DTS: September 2021 To Present The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Based on that relationship, we would expect high-yield to perform worse than investment grade since spreads troughed in September 2021, but that has not been the case (Chart 7C). How do we explain the relatively weak performance of investment grade corporates relative to high-yield? One possible explanation is that the industry composition of the investment grade and high-yield bond universes is different. High-yield has a large concentration in the Energy sector while investment grade is more geared toward Financials. Given the recent surge in oil prices, it’s possible that the strong performance of Energy credits is driving the return divergence between investment grade and high-yield. Chart 8 shows the performance of each individual industry group within both investment grade and high-yield since the September 2021 trough in spreads. It shows that Energy bond returns have indeed been stronger than for other sectors. In fact, high-yield Energy excess returns have been positive! Chart 8Corporate Bond Excess Returns* Versus DTS: September 2021 To Present The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion However, Chart 8 mainly reveals that industry composition only explains part of the divergence between investment grade and high-yield returns. Notice that every single high-yield industry group has outperformed its investment grade counterpart since September 2021. This suggests that there is a more fundamental reason for the divergence between investment grade and high-yield performance. Chart 9Following The 2018 Roadmap Following The 2018 Roadmap Following The 2018 Roadmap Our own sense is that the corporate bond market is following the roadmap from early 2018 (Chart 9). At that time, Fed tightening pushed the Treasury slope below 50 bps and investment grade corporates started to perform poorly, presumably because the removal of monetary accommodation justified somewhat wider corporate bond spreads. However, high-yield performed well in early 2018 as there was no material increase in corporate default risk, even though the Fed was tightening. A similar market narrative could easily be applied to today. Back in 2018, the market narrative shifted late in the year when investors suddenly decided that Fed tightening had gone too far. High-Yield sold off sharply and caught up with investment grade. The Fed was then forced to end its tightening cycle and corporate bonds rallied in early 2019. We see this 2018 roadmap as a significant risk, but not destiny. While there’s a chance that the market will soon decide that the Fed has over-tightened, leading to a sharp sell-off in high-yield. There’s also a chance that gradual Fed rate hikes will continue for much longer than the market anticipates without meaningfully slowing the economy. In that case, high-yield returns would remain solid for some time and the recent spread widening in investment grade would probably abate. For the time being, we find ourselves more inclined toward the latter scenario. Bottom Line: Investors should maintain an overweight allocation to high-yield and a neutral allocation to investment grade corporate bonds within a US bond portfolio. We may soon get a chance to upgrade our corporate bond allocation if inflationary pressures abate and the war in Ukraine shows signs of de-escalation. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 PCE data is so far only updated to January 2022. 3 In this report we use Duration-Times-Spread (DTS) as a simple measure of a bond index’s credit risk. A higher DTS means that a bond has greater credit risk and vice-versa. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion Other Recommendations The Implications Of Yield Curve Inversion The Implications Of Yield Curve Inversion

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Image Chart 2The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Image Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Image Chart 5Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 9Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 12An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Chart 13Housing Is In Short Supply Housing Is In Short Supply Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover European Capex Should Recover European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? Image The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Special Trade Recommendations Current MacroQuant Model Scores Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks?

Executive Summary The Market Has Priced An Aggressive Path For US Rate Hikes The Market Has Priced An Aggressive Path For US Rate Hikes The Market Has Priced An Aggressive Path For US Rate Hikes The Federal Reserve has joined other G10 central banks in increasing interest rates this week. However, this has been well priced by both the dollar and short rates in the US (Feature Chart). The key call for currencies therefore is whether the Fed delivers more or less hikes than is currently priced by markets over the course of the next few months. More aggressive rate hikes will boost US bond yields, and send the dollar higher. But it will also undermine US equity multiples, given the tight correlation between the price-to-earnings ratio in the US and the real bond yield. More importantly, US equity market leadership has been an important driver of portfolio inflows into the dollar. Should the Fed deliver less hikes than the aggressive path currently priced by markets, currency investors will also be caught offside. This conundrum puts the DXY at risk. The caveat is that if the US economy is genuinely stronger than the rest of the world, and more insulated from the Russo-Ukrainian conflict, this will warrant higher real US interest rates. We went short NOK/SEK last week given our bias that oil prices had overshot. Tighten stops to protect profits. Bottom Line: Being long the dollar is a consensus trade. While in the near term, this could prove to be the right call, the dollar is also expensive and overbought, which is bearish from a contrarian perspective. Feature The 25 basis point interest rate hike by the Federal Reserve this week has probably been one of the most telegraphed macro events. Interest rate expectations in the US have risen sharply compared to last year (Chart 1). More importantly, as Chart 2 shows, two-year bond yields (a proxy for short rates) have climbed in the US relative to pretty much every other G10 country. Correspondingly, rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. Chart 2The Market Expects The Fed To Hike Faster Than Other Central Banks This Year The Market Expects The Fed To Hike Faster Than Other Central Banks This Year The Market Expects The Fed To Hike Faster Than Other Central Banks This Year Chart 1The Market Has Priced An Aggressive Path For US Rate Hikes The Market Has Priced An Aggressive Path For US Rate Hikes The Market Has Priced An Aggressive Path For US Rate Hikes On the flipside, the outperformance of the US equity market is being threatened by rising interest rates. If rates rise substantially, that could derate US equity multiples, as portfolio inflows are curtailed. US profits also tend to underperform when rates rise. However, if US rates rise by less than what the market expects, net long speculative positioning in the dollar will surely reverse. Non-US Markets Benefit More When Bond Yields Rise Profits tend to drive the equity market over the short run, with valuation starting to matter over longer horizons. When it comes to the US, it is also true that profits tend to underperform the rest of the world as bond yields rise. Why it matters for the dollar is because a better profit picture in the US helps drive portfolio flows into US equities, buffeting the exchange rate (Chart 3). Related Report  Global Investment StrategyA Two-Stage Fed Tightening Cycle Chart 4 shows that US profits lag the rest of the world when bond yields are in an uptrend. This is because of the composition of the US equity market. Specifically, the US equity market is underweight financials, energy, materials, and industrials, while overweight information technology, health care, and communication services. Rising inflation benefits commodity-linked sectors, the income statements of which are directly juiced by rising prices. Similarly, banks tend to do better as interest rates rise because net interest margins improve. In a nutshell, rising rates and inflation tend to be better for the profits of value stocks and cyclicals, sectors that are underrepresented in the US. Chart 3The Dollar And US Equities The Dollar And US Equities The Dollar And US Equities Chart 4Bond Yields And US Profits Bond Yields And US Profits Bond Yields And US Profits There is also a valuation angle to higher rates. Because the US market is more overweight sectors with cash flows that backwardated, higher rates will undermine the valuation premium currently commanded by these sectors. This is true both in absolute terms and relative to other markets (Chart 5A and 5B). Chart 5AThe S&P 500 P/E Ratio And Real ##br##Yields The S&P 500 P/E Ratio And Real Yields The S&P 500 P/E Ratio And Real Yields Chart 5BThe Valuation Premium In The US Is Inversely Correlated To Bond Yields The Valuation Premium In The US Is Inversely Correlated To Bond Yields The Valuation Premium In The US Is Inversely Correlated To Bond Yields The key point is that the US equity market is at risk relatively from higher global yields that could undermine relative profit growth and its valuation premium. The US trade deficit currently runs at $90 billion. In 2021, at least 45% of that was financed via foreign equity purchases. A reversal in these flows could undermine the dollar. The Dollar And Relative Interest Rates While portfolio flows into US equities have been reversing, bond inflows have improved (Chart 6). Over the long term, bond flows tend to be the key driver of the US dollar. As Chart 2 shows, most market participants expect the Fed to be among the most hawkish central banks in 2022 and beyond. In fact, December Eurodollar contracts are pricing the Fed to hike interest rates by 218 bps more than the ECB, and 235 bps more than the Bank of Japan (allowing for a small risk premium in this pricing) (Chart 7). Chart 7Investors Are Very Bullish On US Rate Expectations Investors Are Very Bullish On US Rate Expectations Investors Are Very Bullish On US Rate Expectations Chart 6Investors Have Been Aggressively Purchasing US Treasurys Investors Have Been Aggressively Purchasing US Treasurys Investors Have Been Aggressively Purchasing US Treasurys There are two key risks to a hawkish Fed view, relative to other central banks: First, the Fed is already behind the curve relative to its G10 counterparts. The BoE, RBNZ, BoC, and the Norges Bank have already increased rates. Even the rhetoric at the ECB is shifiting. Relative bond yields do not reflect this reality. Second, and related, rising inflation is a global phenomenon and not specific to the US. Almost every central bank is acknowledging that inflation is a key risk to their mandate, compared to the transitory narrative last year. Chart 8 plots headline inflation across G10 countries. On this basis, it becomes difficult to justify why two-year yields in the UK, for example, are much lower, compared to the US. Chart 8Rising Inflation Is Not A US-Centric Problem Rising Inflation Is Not A US-Centric Problem Rising Inflation Is Not A US-Centric Problem If inflation does indeed prove to be sticky, other central banks will have to keep hiking interest rates along with the Fed. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. On a relative basis, this suggests there is a mispricing of how the market views Fed action, relative to other central banks. The key risk to this view is that the US economy can actually withstand much higher rates compared to the rest of the world. While this could be the case, higher rates in Norway and New Zealand are not yet hurting domestic conditions. In fact, it can be argued that weakness in their currencies has unwound a lot of the tightening in financial conditions from higher interest rates. A commodity boom also suggests that these currencies will benefit from rising terms of trade. Conclusion Bond markets have priced higher relative rates in the US, but the Fed could actually lag market expectations, especially relative to commodity-linked currencies (Chart 9). Chart 9Commodity Currencies Have Been Tracking Rate Expectations With A Lag Commodity Currencies Have Been Tracking Rate Expectations With A Lag Commodity Currencies Have Been Tracking Rate Expectations With A Lag Specifically, higher rates than the market expects in the US will undermine US equity market leadership, reversing substantial portfolio inflows in recent years. This is already occurring at the margin. On the other hand, fewer rate hikes will severely unwind speculative inflows into the US dollar. Housekeeping We went short NOK/SEK on the expectation that oil prices had overshot, especially relative to forward markets (Chart 10). We are tightening the stop loss on this trade to 1.09. Finally, the Bank of England met this week and its transcript reinforced our stance that the BoE will be cornered as it attempts to raise rates amidst a slowing economy. Stay long EUR/GBP. Chart 10Stay Short NOK/SEK But Tighten Stops Stay Short NOK/SEK But Tighten Stops Stay Short NOK/SEK But Tighten Stops   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’  Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Go Long EUR/CHF Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2  Source: Bureau of Labor Statistics Fractal Trading System Fractal Trades The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy The Fed Needs A ‘Hail Mary’ To Maintain Credibility Without Crashing The Economy 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations