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Highlights Our top five “black swan” risks for 2022: Social unrest in China; Russian invasion of all of Ukraine; unilateral Israeli strikes on Iran; a cyber attack that goes kinetic; and a failure of OPEC 2.0. Too early to buy the dip on Russian assets: President Biden says Putin will probably “move in” and re-invade Ukraine, Russian embassy staff have been evacuating Ukraine, the US and UK have been providing more arms to Ukraine, and the US is warning of a semiconductor embargo against Russia. Talks resume in Geneva on Friday. Tactically investors should take some risk off the table, especially if linked to Russia and Europe.  Stay short the Russian ruble and EM Europe; stay short the Chinese renminbi and Taiwanese dollar; stay long cyber security stocks; and be prepared for oil volatility. Convert tactical long equity trades to relative trades: long large caps versus small caps, long defensives versus cyclicals, and long Japanese industrials versus German industrials. Feature Chart 1Recession Probability And Yield Curve The 2/10-year yield curve is flattening and now stands at 79 bps, while the implied probability of a recession over the next 12 months troughed at 5.9% in April 2021, and as of December 2021 stood at 7.7% (Chart 1). Apparently stagflation and recession are too high of a probability to constitute a “black swan” risk for this year. Black swans are not only high impact but also low probability. In this year’s annual “Five Black Swan” report, the last of our 2022 outlook series, we concentrate on impactful but unlikely events. These black swans emerge directly from the existing themes and trends in our research – they are not plucked at random. The key regions are highlighted in Map 1. Black Swan #1: Major Social Unrest Erupts In China China’s financial problems are front and center risks for investors this year. They qualify as a “Gray Rhino” rather than “Black Swan” risk.1 It is entirely probable that China’s financial and property sector distress will negatively impact Chinese and global financial markets in 2022. What investors are not expecting is an eruption of social unrest in China that fouls up the twentieth national party congress this fall and calls into question the Communist Party’s official narrative that it is handling the pandemic and the underlying economic transition smoothly. Social unrest is a major risk around the world in the face of the new bout of inflation. Most of the democracies have already changed governments since the pandemic began, recapitalizing their political systems, but major emerging markets – Russia, India, Turkey, Brazil – have not done so. They have seen steep losses of popular support for both political leaders and ruling parties. There is little opinion polling from China and people who are surveyed cannot speak openly. It is possible that the government’s support has risen given its minimization of deaths from the pandemic. But it is also possible that it has not. Beijing’s policies over the past few years have had a negative impact on the country’s business elite and foreign relations. There are disgruntled factions within China, though the current administration has a tight grip over the main organs of power. Since President Xi is trying to clinch his personal rule this fall, sending China down a path of autocracy that proved disastrous under Chairman Mao Zedong, it is possible he will face surprise resistance. China’s economic growth is decelerating, clocking in at a 4.0% quarter-on-quarter growth rate at the end of last year. While authorities are easing policy to secure the recovery, there is a danger of insufficient support. Private sentiment will remain gloomy, as reflected by weak money velocity and a low propensity to spend among both businesses and households (Chart 2). The government will continue to be repressive in the lead up to the political reshuffle. At least for the first half of the year the economy will remain troubled. Structurally China is ripe for social unrest. It suffers from high income inequality and low social mobility, comparable to the US and Brazil, which are both struggling with political upheaval (Chart 3). Chart 2China's Private Sector Still Depressed​​​​​ ​​​​​​ In addition China is keeping a stranglehold over Covid-19. This “Zero Covid” policy minimizes deaths but suppresses economic activity. Strict policy has also left the population with a very low level of natural immunity and the new Omicron variant is even more contagious than other variants. Hence the regime is highly likely to double down to prevent an explosive outbreak. The service side of the economy will continue to suffer if strict lockdowns are maintained, exacerbating household and business financial difficulties (Chart 4). Yet in other countries around the world, government decisions to return to lockdowns have sparked unrest. Chart 4Zero Covid Policy: Not Sustainable Beyond 2022 China’s “Misery Index” (unemployment plus inflation) is rising sharply. While misery is ostensibly lower than that of other emerging markets, China’s unemployment data is widely known to be unreliable. If we take a worst-case scenario, looking at youth unemployment and fuel prices, misery is a lot higher (Chart 5). The youth, who are having the hardest time finding jobs, are also the most likely to protest if conditions become intolerable (Chart 6). Of course, if social unrest is limited to students, it will lack support among the wider populace. But it is inflation, not youth activism, that is the reason for China’s authorities to be concerned, as inflation is a generalized problem that affects workers as well as students. Chart 5China's Misery Index Is Higher Than It Looks​​​​​ Chart 6China's Troubled Youth Why would protesters stick their necks out knowing that the Communist Party will react ferociously to any sign of instability during President Xi Jinping’s political reshuffle? True, mainland Chinese do not have the propensity to political activism that flared up in protests in Hong Kong in recent years. Also the police state will move rapidly to repress any unrest. Yet the entire focus of Xi Jinping’s administration, since 2012, has been the restoration of political legitimacy and prevention of popular discontent. Xi has cracked down on corruption, pollution, housing prices, education prices, and has announced his “Common Prosperity” agenda to placate the low and middle classes.2 The regime has also cracked down on the media, social media, civil society, and ideological dissent to prevent political opposition from taking root. If the government were not concerned about social instability, it would not have been adopting these policies. Disease, often accompanied by famines or riots, has played a role in the downfall of six out of ten dynasties, so Beijing will not be taking risks for granted (Table 1). Table 1Disease And Downfall Of Chinese Dynasties Social instability would have a major impact as it would affect China’s stability and global investor sentiment toward China. Western democracies would penalize China for violations of human rights, leaving China even more isolated. Bottom Line: Investors should stay short the renminbi and neutral Chinese equities. Foreign investors should steer clear of Chinese bonds in the event of US sanctions. After the party congress this fall there will be an opportunity to reassess whether Xi Jinping will “let a hundred flowers bloom,” thus improving the internal and external political and investment environment, but this is not at all clear today. Black Swan #2: Russia Invades All (Not Just Part) Of Ukraine US-Russia relations are on the verge of total collapse and Russian equities have sold off, in line with our bearish recommendations in reports over the past two years. Russia’s threat of re-invading Ukraine is credible. Western nations are still wishy-washy about the counter-threat of economic sanctions, judging by German Chancellor Olaf Scholz’s latest comments, and none are claiming they will go to war to defend Ukraine.3 Russia is looking to remove the threat of Ukraine integrating militarily and economically with the West. The US and UK are providing Ukraine with defense weaponry even as Russia specifically demands that they cease to do so. President Putin may choose short-term economic pain for long-term security gain. The consensus view is that if Russia does invade, it will undertake a limited invasion. But what if Russia invades all of Ukraine? To be clear, a full invasion is unlikely because it would be far more difficult and costly for Russia. It would go against Putin’s strategy of calculated risk and limited conflict. Table 2 compares Russia and Ukraine in size and strength, alongside a comparison of the US and Iraq in 2002. This is not a bad comparison given that Ukraine’s and Iraq’s land area and active military personnel are comparable. Table 2Russia-Ukraine Balance Of Power 2022 Compared To US-Iraq 2002 Russia would be biting off a much bigger challenge than the US did. Ukraine’s prime age population is 2.5 times larger than Iraq’s in 2002, and its military expenditure is three times bigger. The US GDP and military spending were 150 and 250 times bigger than Iraq’s, while Russia’s GDP and military spending are about ten times bigger than Ukraine’s today. Iraq was not vital to American national security, whereas Ukraine is vital to Russia; Russia has more at stake and is willing to take greater risks. But Ukraine is in better shape to resist Russian occupation than Iraq was to resist American. The point is that the US invasion went smoothly at first, then got bogged down in insurgency, and ultimately backfired both in political and geopolitical terms. Russia would be undertaking a massive expense of blood and treasure that seems out of proportion with its goal, which is to neutralize Ukraine’s potential to become a western defense ally and host of “military infrastructure.” However, there are drawbacks to partial invasion. The remainder of the Ukrainian state would be unified and mobilized, capable of integrating with the western world, and willing to support a permanent insurgency against Russian troops in eastern Ukraine. Russia has forces in Belarus, Crimea, and the Black Sea, as well as on Ukraine’s eastern border, giving rise to fears that Russia could attempt a three-pronged invasion of the whole country. In short, it is conceivable that Russian leaders could make the Soviet mistake of overreaching in the military aims, or that a war in eastern Ukraine could inadvertently expand into the west. If Russia tries to conquer all of Ukraine, the global impact will be massive. A war of this size on the European continent for the first time since World War II would shake governments and populations to their bones. The borders with Poland, Romania, the Baltic states, Slovakia, Hungary, Finland and the Black Sea area would become militarized (Map 2). NATO actions to secure its members and fortify their borders would exacerbate tensions with Russia and fan fears of a wider war. Trade flows would become subject to commerce destruction, affecting even neutral nations, including in the Black Sea. Energy supplies would tighten further, sending Russia and probably Europe into recession. The disruption to business and travel across eastern Europe would be deep and lasting, not only due to sanctions but also due to a deep risk-aversion that would affect foreign investors in the former Soviet Union and former Warsaw Pact. Germany would be forced to quit sitting on the fence, as it would be pressured by the US and the rest of Europe to stand shoulder to shoulder in the face of such aggression. Finland and Sweden would be much more likely to join NATO, exacerbating Russia’s security fears. Russia would suffer a drastic loss of trade, resulting in recession, and its currency collapse would feed inflation (Chart 7). Chart 7Inflation Poses Long-Term Threat To Putin Regime Ultimately the consequences would be negative for the Putin regime and Russia as a result of recession and international isolation. But in the short run the Russian people would rally around the flag and support a war designed to prevent NATO from stationing missiles on their doorstep. And their isolation would not be total, as they would strengthen ties with China and conduct trade via proxy states in the former Soviet Union. Bottom Line: A full-scale invasion of all of Ukraine is highly unlikely because it would be so costly for Russia in military, economic, and political terms. But the probability is not zero, especially because a partial re-invasion could lead to a larger war. While global investors would react in a moderate risk-off matter to a limited war in eastern Ukraine, a full-scale war would trigger a massive global flight to safety as it would call into question the entire post-WWII peace regime in Europe. Black Swan #3: Israel Attacks Iran The “bull market in Iran tensions” continues as there is not yet a replacement for the 2015 nuclear deal that the US abrogated. Our 2022 forecast that the UAE would get caught in the crossfire was confirmed on January 17 when Iran-backed Houthi rebels expanded their range of operations and struck Abu Dhabi (Map 3). The secret war is escalating and US-led diplomacy is faltering. Iran is not going to give up its nuclear program. North Korea achieved nuclear arms and greater military security and is now developing first and second strike capabilities. Meanwhile Ukraine, which faces another Russian invasion, exemplifies what happens to regimes that give up nuclear arms (as do Libya and Iraq). Iran appears to be choosing the North Korean route. While we cannot rule out a minor agreement between President Biden and Iranian President Ebrahim Raisi, we can rule out a substantial deal that halts Iran’s nuclear and missile progress. Here’s why: Any day now Iran could reach nuclear “breakout capacity,” with enough highly enriched uranium to construct a nuclear device (Table 3).4 Table 3Iran’s Violations Of 2015 Nuclear Deal Since US Exit Within Iran’s government, the foreign policy doves have been humiliated and kicked out of office while the hawks are fully in control. No meaningful agreement can be reached before 2024 because of the risk that the US will change ruling parties again and renege on any promises. Iran is highly incentivized to make rapid progress on its nuclear program now. The US will not be able to lead the P5+1 coalition to force Iran to halt its program because of its ongoing struggles with Russia and China. China is striking long-term cooperation deals with Iran. Israel has a well-established record of taking unilateral action, specifically against regional nuclear programs, known as the “Begin Doctrine.”5 Israel’s threats are credible on this front, although Iran is a much greater operational challenge than Iraq or Syria. Iran’s timeline from nuclear breakout to deliverable nuclear weapon is 12-24 months.6 Iran’s missile program is advanced. Missile programs cannot be monitored as easily as nuclear activity, so foreign powers base the threshold on nuclear capability rather than missile capability. Iran had a strong incentive to move slowly on its nuclear and missile programs in earlier years, to prevent US and Israeli military interference. But as it approaches breakout capacity it has an incentive to accelerate its tempo to a mad dash to achieve nuclear weaponization before the US or Israel can stop it. Now that time may have come. The Biden administration is afraid of higher oil prices and Israeli domestic politics are more divided and risk-averse than before. And yet Iran’s window might close in 2025, as the US could turn aggressive again depending on the outcome of the 2024 election. Hence Iran has an incentive to make its dash now. The US and Israel will restate their red lines against Iranian nuclear weaponization and brandish their military options this year. But the Biden administration will be risk-averse since it does not want to instigate an oil shock in an election year. Israel is more likely than the US to react quickly and forcefully since it is in greatest danger if Iran surprises the world with rapid weaponization. Here are the known constraints on unilateral Israeli military action: Limited Israeli military capability: Israel would have to commit a large number of aircraft, leaving its home front exposed, and even with US “bunker buster” bombs it may not penetrate the underground Fordow nuclear facility.7 Limited Israeli domestic support: The Israeli public is divided on whether to attack Iran. The post-Netanyahu government recently came around to endorsing the US’s attempt to renegotiate the nuclear deal. Limited US support: Washington opposes Israeli unilateralism that could entangle the US into a war. Israel cannot afford to alienate the US, which is its primary security guarantor. Iranian instability: The Iranian regime is under economic distress due to “maximum pressure” sanctions. It is vulnerable to social unrest, not least because of its large youth population. These constraints have been vitiated in various ways, which is why we raise this Israeli unilateralism as a black swan risk: Where there’s a will, there’s a way: If Israel believes its existence will be threatened, it will be willing to take much greater operational risks. It has already shown some ability to set back Iran's centrifuge program beyond the expected.8 Israeli opinion will harden if Iran breaks out: If Iran reaches nuclear breakout or tests a nuclear device, Israeli opinion will harden in favor of military strikes. Prime Minister Naftali Bennett has an incentive to take hawkish actions before he hands the reins of government over to a partner in his ruling coalition as part of a power-sharing agreement. The ruling coalition is so weak that a collapse cannot be ruled out. US opposition could weaken: Biden will have to explore military options if talks fail and Iran reaches nuclear breakout capacity. Once the midterms are over, Israel may have even more freedom to act, while a gridlocked Biden may be looking to shift his focus to foreign policy. Iranian stability: Iran’s social instability has not resulted in massive unrest or regime fracture despite years of western sanctions and a global recession/pandemic. Yet now energy prices are rising and Iran has less reason to believe sanction regimes will be watertight. From Israeli’s point of view, even regime change in Iran would not remove the nuclear threat once nuclear weapons are obtained. Finally, while Israel cannot guarantee that military strikes would successfully cripple Iran’s nuclear program and prevent weaponization, Israel cannot afford not to try. It would be a worse outcome to stand idly by while Iran gets a nuclear weapon than to attack and fail to set that program back. Hence the likeliest outcome over the long run is that Iran pursues a nuclear weapon and Israel attacks to try to stop it, even if that attack is likely to fail (Diagram 1). Diagram 1Game Theory: Will Israel Attack Iran? Bottom Line: A unilateral Israeli strike is unlikely but would have a massive impact, as 21% of global oil and 26% of natural gas flows through the Strait of Hormuz, and conflict could disrupt regional energy production and/or block passage through the strait itself. Black Swan #4: Cyber Attacks Spill Into Real World Investors are very aware of cyber security risks – it holds a respectable though not commanding position in the ranks of likely crisis events (Table 4). Our concern is that a cyber attack could spill over into the real world, impairing critical infrastructure, supply chains, and/or prompting military retaliation. Table 4Cyber Events Underrated In Consensus View Of Global Risks Russian attacks on US critical infrastructure by means of ransomware gangs disrupted a US fuel pipeline, meat-packing plant, and other critical infrastructure in 2021. Since then the two countries have engaged in negotiations over cyber security. The Russian Federal Security Bureau has cracked down on one of the most prominent gangs, REvil, in a sign that the US and Russia are still negotiating despite the showdown over Ukraine.9 Yet a re-invasion of Ukraine would shatter any hope of cooperation in the cyber realm or elsewhere. Russia is already using cyberattacks against Ukraine and these activities could expand to Ukraine’s partners if the military conflict expands. Should the US and EU impose sweeping sanctions that damage Russia’s economy, Russia could retaliate, not only by tightening energy supply but also by cyber attacks. Any NATO partners or allies would be vulnerable, though some states will be more reactive than others. Interference in the French election, for example, would be incendiary. The key question is: if Russia strikes NATO states with damaging cyber attacks, at what point would it trigger Article V, the mutual defense clause? There are no established codes of conduct or red lines in cyber space, so the world will have to learn each nation’s limits via confrontation and retaliation. Similar cyber risks could emerge from other conflicts. China is probably not ready to invade Taiwan but it has an interest in imposing economic costs on the island ahead of this fall’s midterm elections. Taiwan’s critical role in the semiconductor supply chain means that disruptions to production would have a global impact. Israel and the US have already used cyber capabilities to attack Iran and set back its nuclear program. These capabilities will be necessary as Iran approaches breakout capacity. Yet Iran could retaliate in a way that disrupts oil supplies. North Korea began a new cycle of provocations last September, accelerated missile tests over the past four months, and is dissatisfied with the unfinished diplomatic business of the Trump administration. In the wake of the last global crisis, 2010, it staged multiple military attacks against South Korea. South Korea may be vulnerable due to its presidential elections in May. The semiconductor or electronics supply chain could be interrupted here as well as in Taiwan. Bottom Line: There is no code of conduct in cyber space. As geopolitical tensions rise, and nations test the limits of their cyber capabilities, there is potential for critical infrastructure to be impaired. This could exacerbate supply chain kinks or provoke kinetic responses from victim nations. Black Swan #5: OPEC 2.0 Falls Apart The basis of the OPEC 2.0 cartel is Russian cooperation with Saudi Arabia to control oil supply and manage the forward price curve. Backwardation, when short-term prices are higher than long-term, is ideal for these countries since they fear that long-term prices will fall. In a world where Moscow and Riyadh both face competition from US shale producers as well as the green energy revolution, cooperation makes sense. Yet the two sides do not trust each other. Cooperation broke down both in 2014 and 2020, sending oil prices plunging. Falling global demand ignited a scramble for market share. Interestingly, Russian military invasions have signaled peak oil price in 1979, 2008, and 2014. Russia, like other petro-states, has greater room for maneuver when oil revenues are pouring in. But high prices also incentivize production, disincentivize cartel discipline, and trigger reductions in global demand (Chart 8). Chart 8Russian Invasions And Oil Price Crashes Broadly speaking, Saudi oil production rose modestly during times of Russian military adventures, while overall OPEC production was flat or down, and Russian/Soviet production went up (Chart 9). Chart 9Saudi And OPEC Oil Production During Russian Military Adventures Since 2020, we have held that OPEC 2.0 would continue operating but that the biggest risk would come in the form of a renewed US-Iran nuclear deal that freed up Iranian oil exports. In 2014, the Saudis increased production in the face of the US shale threat as well as the Iranian threat. This scenario is still possible in 2022 but it has become a low-probability outcome. Even aside from the Iran dynamic, there is some probability that Russo-Saudi cooperation breaks down as global growth decelerates and new oil supply comes online. Bottom Line: The world’s inflation expectations are elevated and closely linked to oil prices. Yet oil prices hinge on an uneasy political agreement between Russia and Saudi Arabia that has fallen apart twice before. If Russia invades Ukraine, or if US withdraws sanctions on Iran, for example, then Saudi Arabia could make a bid to expand its market share and trigger price declines in the process. Two Bonus Black Swans: Turkey And Venezuela Turkey lashes out: Our Turkish Political Capital Index shows deterioration for President Recep Erdogan’s political capital across a range of variables (Table 5). With geopolitical pressures increasing, and domestic politics heating up ahead of the 2023 elections, Erdogan’s behavior will become even more erratic. His foreign policy could become aggressive, keeping the lira under pressure and/or weighing on European assets. Table 5Turkey: Erdogan’s Political Capital Wearing Thin Venezuela’s Maduro falls from power: Venezuelan regime changes often follow from military coups. These coups do not only happen when oil prices collapse – sometimes the army officers wait to be sure prices have recovered. Coup-throwers want strong oil revenues to support their new rule. An unexpected change of regimes would affect the oil market due to this country’s giant reserves. Bottom Line: Turkey’s political instability could result in foreign aggression, while Venezuela’s regime could collapse despite the oil price recovery. Investment Takeaways We are booking profits on our tactical long trades on large caps and defensive sectors. We will convert these to relative trades: long large caps over small caps, and long defensives over cyclicals. We also recommend converting our tactical long Japan trade into long Japanese industrials / short German industrials equities. If US-Russia diplomacy averts a war we will reconsider.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      “Gray Rhino” is a term coined by author Michele Wucker to describe large and probable risks that people neglect or avoid. For more, see thegrayrhino.com. 2     Xi Jinping recently characterized the “common prosperity” agenda as follows: “China has made it clear that we strive for more visible and substantive progress in the well-rounded development of individuals and the common prosperity of the entire population. We are working hard on all fronts to deliver this goal. The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements. As a rising tide lifts all boats, everyone will get a fair share from development, and development gains will benefit all our people in a more substantial and equitable way.” See World Economic Forum, “President Xi Jinping’s message to The Davos Agenda in full,” January 17, 2022, weforum.org. 3     Chancellor Scholz, when asked whether Germany would avoid using the Nord Stream II pipeline if Russia re-invaded Ukraine, said, "it is clear that there will be a high cost and that all this will have to be discussed if there is a military intervention against Ukraine.” He was speaking with NATO Secretary-General Jens Stoltenberg. See Hans Von Der Burchard, “Scholz: Germany will discuss Nord Stream 2 penalties if Russia attacks Ukraine,” Politico, January 18, 2022, politico.eu. 4     For the Begin Doctrine, see Meir Y. Soloveichik, “The Miracle of Osirak,” Commentary, April 2021, commentary.org. 5     The estimate of 12-24 months to mount a nuclear warhead on a missile has been cited by various credible sources, including David Albright and Sarah Burkhard, “Highlights of Iran’s Perilous Pursuit of Nuclear Weapons,” Institute for Science and International Security, August 24, 2021, isis-online.org, and Eric Brewer and Nicholas L. Miller, “A Redline for Iran?” Foreign Affairs, December 23, 2021, foreignaffairs.com. 6     See Edieal J. Pinker, Joseph Szmerekovsky, and Vera Tilson, “Technical Note – Managing a Secret Project,” Operations Research, February 5, 2013, pubsonline.informs.org, as well as “What Can Game Theory Tell Us About Iran’s Nuclear Intentions?” Yale Insights, March 17, 2015, insights.som.yale.edu.  7     See Josef Joffe, “Increasingly Isolated, Israel Must Rely On Nuclear Deterrence,” Strategika 35 (September 2016), Hoover Institution, hoover.org. 8     The sabotage of the Iran Centrifuge Assembly Center at the Natanz nuclear facility in July 2020 “set back Iran’s centrifuge program significantly and continues to do so,” according to David Albright, Sarah Burkhard, and John Hannah, “Iran’s Natanz Tunnel Complex: Deeper, Larger Than Expected,” Institute for Science and International Security, January 13, 2022, isis-online.org. For a recent positive case regarding Israel’s capabilities, see Mitchell Bard, “Military Options Against Iran,” Jewish Virtual Library, American-Israeli Cooperative Enterprise, January 2022, jewishvirtuallibrary.org.  9     For the FSB and REvil, see Chris Galford, “Russian FSB arrests members of REvil ransomware gang following attacks on U.S. infrastructure,” Homeland Preparedness News, January 18, 2022, homelandprepnews.com. For the Colonial Pipeline and JBS attacks, and other ransomware attacks, see Jonathan W. Welburn and Quentin E. Hodgson, “How the United States Can Deter Ransomware Attacks,” RAND Blog, August 9, 2021, rand.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights US Vs. Europe: Growth and inflation momentum remains stronger in the US versus Europe. The latter is taking the bigger economic hit from more severe Omicron economic restrictions and a greater exposure to slowing Chinese demand. European inflation has accelerated, but remains slower and less broad-based than elevated US inflation. The backdrop remains more negative for US fixed income compared to Europe. UST-Bund Spread: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures). Feature Chart of the WeekUS Bond Yields & Bond Volatility Are Both Rising Global fixed income markets are off to a volatile start in 2022, on the back of significant repricing of US interest rate expectations. The 10-year US Treasury yield now sits at 1.85%, up +34bps so far in January and is up +72bps from the August 4/2021 intraday low of 1.13%. The 2-year US yield, which is even more sensitive to changes in Fed expectations, is 1.04%, up +31bps so far this month and up +87bps since early August 2021. Yields are rising in other countries as well, with the 10-year benchmark government bond yield up year-to-date in the UK (+24bps), Canada (+45bps) and even Germany (+18bps) where the Bund yield is threatening to return to positive territory. US Treasuries are selling off as markets have heeded the hawkish shift in the Fed’s interest rate guidance. The US overnight index swap (OIS) curve now discounting 89bps of Fed rate hikes in 2022. Bond volatility further out the Treasury curve has increased as yields have moved higher, with the realized volatility of the Bloomberg 7-10 US Treasury index now at an 19-month high (Chart of the Week). We continue to recommend a defensive strategic posture towards direct US Treasuries with below-benchmark exposure on both duration and country allocations in global bond portfolios. However, we prefer a more efficient way to position for the same theme of rising US yields – betting on a wider 10-year US Treasury-German Bund spread. US Growth & Inflation Fundamentals Support A More Hawkish Fed The rise in global bond yields seen in recent weeks has inflicted damage on risk assets, but not in a consistent fashion. Equity markets have taken the brunt of the hit, with the S&P 500 down around -3% so far in January with the tech-heavy NASDAQ down -6%. Yet the MSCI emerging market equity index is up around +1%, European equities are flat and global high-yield corporate bond spreads are essentially unchanged so far this month. While higher bond yields are reflecting expectations of more global monetary tightening over the next year, medium-term interest rate expectations remain subdued. Our proxy for the market pricing of terminal interest rate expectations – 5-year OIS rates, 5-years forward – remains at or below pre-pandemic levels in the US, the UK, Canada and the euro area (Chart 2). Risk assets are performing relatively well in the face of higher bond yields because markets still do not believe that a major increase in interest rates will be needed in the current global tightening cycle. We see this – the likelihood that interest rates will have to rise much more than markets expect - as the biggest vulnerability for global bond markets over the next couple of years. The US remains the “poster child” for this view. In the US, core CPI inflation accelerated to an 31-year high of 5.5% in December. The pickup in US inflation continues to be broad-based, with the Cleveland Fed median CPI and trimmed mean CPI inflation measures reaching 3.8% and 4.8%, respectively (Chart 3). This massive run-up in US inflation has filtered through to medium-term household inflation expectations; the preliminary University of Michigan consumer survey for January showed that inflation 5-10 years out is expected to be 3.1% - the highest level in 13 years. Chart 2Rising Yields Are Not A Threat To Risk Assets ... Yet​​​​​ Chart 3The Fed Cannot Ignore Elevated Inflation Expectations​​​​​​ Chart 4US Demand Steadily Normalizing From The Pandemic Shock While much of the run-up in US inflation over the past year has been fueled by supply chain disruption and high energy prices, there is still a robust demand component to the high inflation. Consumer spending on goods remains elevated versus its pre-pandemic trend, while services spending is steadily returning back to the pre-pandemic pace (Chart 4). The overall US unemployment rate is now down to 3.9%, the lowest level since February 2020, with broad-based strength in the US labor market across most industries (bottom panel). The rise in consumer inflation expectations has to be most worrisome to Fed officials. Yes, market-based inflation expectations have already seen a significant run-up since the mid-2020 lows, and have even drifted down a bit of late on the back of the more hawkish rhetoric from the Fed. However, survey-based measures of inflation expectations tend to be less volatile than market-based measures, and typically follow trends in realized inflation, which is not slowing down in the US. In other words, rising household inflation expectations are a more reliable indication that an inflationary mindset is becoming entrenched in consumer behavior. US inflation dynamics are transitioning away from supply-driven goods inflation toward more lasting domestically driven forces like tight labor markets, faster wage growth and rising housing costs (Chart 5). Measures of supply chain disruption like global shipping costs are showing signs of peaking (top panel), while commodity price momentum has clearly rolled over – both should eventually feed into slower goods inflation this year. At the same time, tight labor markets will continue to boost US employment costs, which historically have been strongly correlated to US services inflation (middle panel). Chart 5US Inflation Pressures Remain Intense Meanwhile, shelter costs, which represents 32% of the US CPI index, were up 4.2% on a year-over-year basis in December and are likely to continue accelerating given a dearth of housing supply versus demand that is pushing up both house prices and rents (bottom panel). Tying it all together, there are good reasons why the Fed has ramped up the hawkish rhetoric over the past couple of months. However, with the US OIS curve now discounting between 3-4 rate hikes in 2022, it will be harder to generate a second consecutive year of negative returns in the US Treasury market this year. Dating back to the early 1970s, there have only been five calendar years where the Bloomberg US Treasury index delivered an outright negative total return: 1994, 1999, 2009, 2013 and 2021 (Chart 6). None of the four cases prior to last year saw negative returns in the following year, as Treasury yields fell in 1995, 2000, 2010, 2014. Yet even the episodes that saw consecutive years of US yield increases – 1974-75, 1977-81, 1987-88, 2005-06 and 2015-16 – did not see outright negative returns from the Bloomberg US Treasury index. Chart 6Negative Return Years For US Treasuries Are Rare Given the starting point of deeply negative real US bond yields, and interest rate expectations that remain too low beyond 2022, we still see value in staying below-benchmark on US duration exposure on a medium-term basis. However, we see a more efficient way to play for higher Treasury yields this year by positioning US Treasury underweights/shorts versus overweights/longs in government bonds in a region where discounted rate hikes will not happen – Europe. The ECB Is In No Hurry To Hike Rates The same supply driven factors that have pushed up US inflation over the past year have also lifted inflation in the euro area. Headline HICP inflation reached an 30-year high of 5.0% in December, while core HICP inflation hit an all-time high of 2.6%. The European Central Bank (ECB), however, is unlikely to deliver any rate hikes in 2022 even with the high inflation, for several reasons (Chart 7): Growth momentum entering 2022 was soft, thanks to Omicron related economic restrictions at the end of 2021 and also weak demand for European exports from China. It will take time for both of those factors to reverse, thus reducing any growth related pressure to tighten monetary policy. Inflation expectations are not exceeding the ECB 2% inflation target, with the 5-year/5-year forward EUR CPI swap now at 1.9% even with headline inflation of 5.0%. The surge in European energy prices will eventually subside in the first half of 2022, which will reduce inflationary pressure on the ECB to tighten. The ECB is ending its pandemic emergency bond buying program (PEPP) in March, and is only partially replacing that buying activity by upsizing its existing pre-pandemic asset purchase program (APP). The ECB will not want to compound the effect of this “tapering” of bond buying by also hiking interest rates, which would surely tighten financial conditions further through higher Italian government bond yields, rising corporate bond yields and a firmer euro. There is little evidence to date showing any pass-through of higher energy-fueled inflation into more domestically-driven inflation. Euro area wage growth was only 1.3% as of the latest available data in Q3/2021 (which is still well after realized inflation had started to accelerate), highlighting the lack of visible “second round” effects on euro area inflation from high energy prices that would prompt the ECB to consider rate hikes (Chart 8). Chart 7An ECB Rate Hike In 2022 Is Unlikely​​​​​​ Chart 8Limited 'Second Round' Effects From Energy-Driven European Inflation​​​​​​ The EUR OIS curve is discounting 7bps of rate hikes by year-end. Even that modest amount will not be delivered, which will limit how much further European government bond yields will rise this year. A Better Mousetrap: Playing UST Bearishness Through UST-Bund Spread Widening Trades Combining our view of an increasingly hawkish Fed and a still-dovish ECB produces our highest conviction investment recommendation for 2022: positioning for a wider 10-year US Treasury/Germany Bund spread. This can be done by underweighting the US versus core Europe in global bond portfolios, or shorting US Treasury futures versus German Bund futures as we are already recommending in our Tactical Trade Overlay (see page 15). A Treasury-Bund spread widening view is a more efficient way to play for a more hawkish Fed and higher US Treasury yields, for several reasons: There are many examples over past 30 years where the Treasury-Bund spread widened in consecutive years (Chart 9). This is in contrast to the fewer occurrences of consecutive years of rising Treasury yields shown earlier in this report. Thus, there are better odds that last year’s Treasury-Bund spread widening can be repeated in 2022. Chart 9Consecutive Years Of A Rising UST-Bund Spread Happen Often The realized volatility of Treasury-Bund spread trades is almost always lower than that of an outright short position in US Treasuries, but the direction of returns of the two trades is similar (Chart 10). This shows that there is directionality in the Treasury-Bund spread (i.e. it is driven far more by the movements of US yields), but that is a welcome feature given our more bearish view on US Treasuries. The Treasury-Bund spread remains well below fair value on our fundamental valuation model, with fair value increasing due to widening US-European inflation differentials (Chart 11). Tighter relative monetary policies this year (more tapering and rate hikes from the Fed compared to the ECB) also favor a wider fair value spread on our model. Chart 10UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts​​​​​ Chart 11The UST-Bund Spread Looks Very Cheap On Our Model​​​​​​ The gap between our 24-month discounters, which measure the change in policy interest rates over the next two years discounted in OIS curves, for the US and euro area is a reliable leading indicator of the 10-year Treasury-Bund spread (Chart 12, bottom panel). The “discounter spread” is currently calling for the Treasury-Bund spread to widen by more than the current path discounted in US Treasury and German Bund forward rates. Chart 12Position For More UST-Bund Spread Widening In 2022​​​​​​ Chart 13UST-Bund Spread Is Not Technically Stretched​​​​​ The Treasury-Bund spread is not stretched from a technical perspective (Chart 13). The spread is sitting right at its 200-day moving average and the 26-week change in the spread (a measure of price momentum) is rising but remains well below previous peak levels that have capped past spread increases. Summing it all up, the case is strong for including US-Germany spread widening positions as core holdings in investor portfolios in 2022. The current spread is 185bps and we have a year-end target of 225bps. Bottom Line: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Duration: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. Interest Rate Policy: The Fed will deliver its first rate hike in March and will lift rates 2 or 3 more times this year. We see the fed funds rate moving above 2% this cycle, higher than what is currently priced in the market. Fed Balance Sheet: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. Feature Chart 1Market Expectations Are Too Low Rate hikes are just around the corner. In fact, there is a growing consensus among FOMC participants that it will be appropriate to deliver the first rate hike in March, as soon as net asset purchases reach zero. Just last week, San Francisco Fed President Mary Daly called a March rate hike “quite reasonable” and Fed Vice-Chair Lael Brainard testified that the Fed will be “in a position” to lift rates as soon as purchases end. Brainard also mentioned that the Fed has discussed shrinking its balance sheet.1 We expect the Fed to follow through with a 25 basis point rate hike in March, and with 2 or 3 more hikes over the course of 2022. We also see the Fed shrinking its balance sheet this year, via the passive runoff of maturing securities. With all that in mind, this week’s report draws on the experience of past rate hike cycles to give us a sense of what Treasury returns to expect as the Fed lifts rates. We also discuss how the Fed’s balance sheet will evolve over the next few years.  Treasury Returns During Rate Hike Cycles Table 1 provides a useful summary of Treasury returns during the prior four rate hike cycles. The table shows excess Treasury returns versus cash for the Bloomberg Barclays Treasury Index as well as its Intermediate Maturity and Long Maturity sub-indexes. Table 1Treasury Returns During Fed Rate Hike Cycles The first conclusion we draw is that Treasury returns are generally poor during Fed tightening cycles. Intermediate maturity Treasuries underperformed cash in all four cycles. Long maturity Treasuries provided only modestly positive returns in two of the four cycles and deeply negative returns in one of them. One important caveat is that our analysis only considers cycles where the Fed lifted rates multiple times in a row. For example, we exclude the 1997-98 period when one rate hike in 1997 was quickly reversed in 1998. We also define the most recent tightening cycle as spanning from 2015 to 2018 even though the Fed kept the policy rate steady from December 2015 to December 2016. Obviously, if the Fed is forced to abandon its tightening cycle after one or two hikes, then Treasury returns will be much stronger than our historical analysis suggests. Next, let’s dig a bit deeper by looking at each rate hike cycle individually. The 2015-2018 Cycle Chart 22015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target fed funds rate by 225 bps, from a range of 0% - 0.25% to a range of 2.25% - 2.5% (Chart 2). If we look at the 36-month discounter on the day before the first hike (Chart 2, panel 3), it shows that the market was priced for 159 bps of tightening over the next three years. The fact that the Fed delivered more tightening (225 bps) explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield is another useful metric because it is a good approximation of the market’s expected terminal fed funds rate, i.e. the fed funds rate at the end of the tightening cycle. The 5-year/5-year forward Treasury yield stood at 2.92% in December 2015, slightly above where the fed funds rate peaked in 2018 (Chart 2, bottom panel). This explains why long-maturity excess Treasury returns were slightly positive during the cycle.         The 2004-2006 Cycle Chart 32004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span (Chart 3). The 24-month fed funds discounter stood at 369 bps the day before the first hike (Chart 3, panel 3), indicating that the market discounted 31 bps less tightening than was ultimately delivered. Once again, this explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield was 5.72% just prior to the first hike in June 2004 (Chart 3, bottom panel). But, as was the case in the 2015-2018 cycle, the fed funds rate never reached this level. It peaked at 5.25% in 2006 and long-maturity excess Treasury yields were somewhat positive as a result.                 The 1999-2000 Cycle Chart 41999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5% (Chart 4). The 12-month fed funds discounter stood at 108 bps on the day before the first hike (Chart 4, panel 3). Once again, this was slightly less than the 175 bps of tightening that transpired. Excess returns for short and intermediate maturity Treasuries were negative as a result. The 5-year/5-year forward Treasury yield was 5.99% on the day before the first hike (Chart 4, bottom panel). This time, the market’s assessment proved to be too low compared to the funds rate’s 6.5% peak. This divergence explains why long-maturity Treasury excess returns were worse during this period than they were in the 2015-18 and 2004-06 cycles.                 The 1994-1995 Cycle Chart 51994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995 (Chart 5). The 12-month discounter was only 130 bps at the beginning of the tightening cycle, well short of the 300 bps rate increase that was delivered (Chart 5, panel 3). This large divergence explains why excess Treasury returns were so poor during this period. Interestingly, the 5-year/5-year forward Treasury yield stood at 6.69% just prior to the first hike (Chart 5, bottom panel), not that far from the ultimate peak in the fed funds rate. In other words, while market expectations for the near-term path of interest rates were too low, expectations for the ultimate peak in interest rates were fairly accurate. However, terminal rate expectations became unmoored when the Fed started to tighten, and the 5-year/5-year forward Treasury yield rose all the way to 8.5%, far above the fed funds rate’s ultimate peak. This dramatic shift in terminal rate expectations explains the deeply negative long-maturity Treasury returns observed during the period. Of course, those losses were quickly reversed in H1 1995 once it became clear that the Fed would not lift rates further. The 5-year/5-year forward Treasury yield plummeted back to 6.5%. Investment Implications Let’s apply the above analysis to today’s situation. At present, the 12-month fed funds discounter stands at 93 bps. The 24-month discounter is 151 bps and the 36-month discounter is 159 bps (Chart 1). In other words, the market is discounting that the Fed will deliver between 3 and 4 rate hikes this year, but only 2 more in 2023 before the funds rate stabilizes at roughly 1.5%. Our expectation is that the fed funds rate will rise to at least 2% during the next three years, and we therefore continue to recommend running below-benchmark portfolio duration. For its part, the 5-year/5-year forward Treasury yield is currently 2.03%. This is at the low-end of survey estimates for the long-run neutral fed funds rate (Chart 1, bottom panel). We expect the 5-year/5-year forward Treasury yield to rise closer to the middle of the range of survey estimates (~2.25%) as it becomes clear that the fed funds rate will rise to at least 2%. It’s also possible that, like in the 1994-95 episode, terminal rate expectations will rise dramatically as the Fed lifts rates more quickly than anticipated. This, however, is not our base case outlook given that expectations for a low terminal fed funds rate are very well entrenched. Bottom Line: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. The Balance Sheet Outlook Chart 6Hike First, Then QT We expect the Fed to start shrinking its securities holdings this year. The process will probably begin in the first half of the year after one or two rate hikes have been delivered. To arrive at this conclusion, we first look at how the Fed proceeded during the last tightening cycle. Back then, the Fed waited until the funds rate was around 1% before it started to shrink its balance sheet in September 2017 (Chart 6). Notably, the Fed didn’t immediately move toward the full passive runoff of its portfolio. Rather, it started slowly by permitting only $6 billion of Treasuries and $4 billion of MBS to mature in October 2017. These amounts were gradually increased in the subsequent months. The Fed will move more quickly toward balance sheet reduction this cycle and the pace of said reduction will be faster. Here are the relevant passages from the minutes of the December FOMC meeting: Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. […] Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. Many participants also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable…2 From these quotes, we surmise that balance sheet runoff will start earlier than last time – after one or two rate hikes instead of four. Also, while the runoff will proceed more quickly than last time, there is still support for maintaining monthly caps on the pace. The Fed will probably not move immediately to the complete passive runoff of its portfolio, and outright bond sales do not appear to be part of the discussion. One concern that investors might have about the Fed’s balance sheet runoff is the extra supply of Treasuries that will hit the market. As an upper-bound, if we assume complete passive runoff starting in April 2022, the Fed’s Treasury holdings will shrink from $5.7 trillion today to $3.5 trillion by the end of 2024, adding an average of $715 billion extra Treasury supply to the market each year (Chart 7). If we exclude T-bills and TIPS to focus only on coupon-paying nominal Treasury securities, then we calculate that Fed holdings will fall from $4.9 trillion to $3 trillion, adding an extra $639 billion of supply to the market on average for the next three years. However, it’s important to note that Fed policy alone doesn’t dictate the supply of Treasury securities. The Treasury department’s issuance plans also need to be considered. When the Fed allows a maturing bond to passively roll off its portfolio it doesn’t dump that bond directly into the market. Rather, the Treasury Department issues new debt to replace the maturing bond. The Treasury could decide, for example, to increase T-bill issuance instead of coupon issuance. In fact, this sort of decision becomes more likely if Treasury officials are concerned about dumping too much coupon supply on the market. Currently, the Treasury Department targets a range of 15% - 20% for the amount of outstanding T-bills as a proportion of the overall funding mix, a target that it is hitting (Chart 8). However, the minutes from the most recent Quarterly Refunding meeting stressed that the Treasury feels the need to maintain “flexibility” when it comes to this target range and noted that “there is likely more leeway at the top of the recommended range than at the bottom.”3 Chart 7The Pace Of ##br##Runoff Chart 8T-bill Issuance Could Rise As The Fed's Portfolio Shrinks Finally, it is important to consider the extent to which the Fed will be able to shrink its balance sheet. The Fed’s goal will be to achieve a reserve supply that allows it to maintain the funds rate within its target band without putting undue pressure on either its Overnight Reverse Repo Facility (ON RRP) or its new Standing Repo Facility (SRF). Chart 9The Fed's Balance Sheet Was Too Small In September 2019 The ON RRP acts as a floor on interest rates and its usage therefore increases when the Fed’s balance sheet is too large. The third panel of Chart 9 shows that this is currently the case. Conversely, the SRF acts as a ceiling on interest rates and its usage will ramp up if the Fed’s balance sheet becomes too small. This last occurred in September 2019 when the Fed briefly lost control of interest rates and was forced to increase repo holdings and reserve supply (Chart 9).​​​​​​​ Going forward, the Fed will continue to run down its balance sheet until ON RRP usage drops close to zero. However, it will want to stop reducing its holdings before SRF usage picks up. It is highly uncertain when this will occur, but we suspect that the Fed won’t be able to get the balance sheet back to September 2019 levels before seeing SRF usage increase. Bottom Line: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. While the size of the Fed’s balance sheet will shrink during the next few years, it will remain larger than it was in September 2019.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see https://www.reuters.com/business/exclusive-feds-daly-march-liftoff-is-quite-reasonable-2022-01-13/ and https://www.nbcnews.com/business/economy/interest-rate-hike-come-soon-march-feds-brainard-signals-rcna12112 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20211215.pdf 3 https://home.treasury.gov/news/press-releases/jy0464 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary   Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights It’s true that rising rates often precipitate bear markets, but it takes a while, … : We subscribe to the view that expansions are more likely to be murdered by the Fed than die of old age. It’s hard to envision a plausible scenario in which the Fed could hike rates enough in 2022 to kill this one, though, and even the first half of 2023 would be a reach.  … because the Fed only seeks to slow the economy when it’s firing on all cylinders: Earnings are typically growing at a rapid clip and risk aversion is a distant memory when the Fed begins the process of draining the punch bowl. The fed funds rate tipping point can only be definitively identified after the fact, but our estimate has an impressive track record: No one knows for sure where the line of demarcation between easy and tight monetary policy lies, but equities have shined when the fed funds rate is below our equilibrium estimate. We do not share the view that Tech stocks are especially vulnerable to higher interest rates: Although it lacks empirical support outside of a small subset of observations, the Tech vulnerability view has spread more widely than the Omicron variant. Feature Last week’s report discussing the equity impact of impending rate hikes elicited a lot of reaction. A discussion with one investor usually has relevance for other investors, so we are sharing a composite of the questions we received, along with our responses. It gives us the chance to elaborate on some points that we did not previously address in full, but our conclusion remains unchanged. History argues that equities have little to fear from an incremental rate hike campaign, and we expect that they will generate sizable positive excess returns above Treasuries and cash over the next twelve months. The Fed, With Rate Hikes, In The Board Room Why shouldn’t investors be concerned about rate hikes when you yourself have said that the Fed precipitates recessions? As the last expansion stretched on for a record length of time, we regularly repeated the line that expansions don’t die of old age, they die because the Fed murders them. It fits well with our tipping point view of rate hikes and we wholly subscribe to it. It is important to bear in mind, however, that the Fed’s tools act much more slowly than the lethal array of objects in the game of Clue. As we highlighted last week, monetary policy acts with long and variable lags and the Fed accordingly tightens it in increments allowing for real-time feedback that might help it tailor its actions to evolving economic conditions. Ex-the pandemic, tight monetary policy has been a necessary, albeit not sufficient, recession condition for the 60 years covered by our equilibrium fed funds rate estimate. Although not every instance when the fed funds rate exceeded its equilibrium level preceded a recession, no recession occurred when the funds rate was below equilibrium (Chart 1). Owing to monetary policy’s lagged effects, however, the recessions didn’t begin until well after the Fed began to tighten policy. On average, each recession arrived 26 months after Phase I kicked off and 12 months after the policy cycle entered Phase II (Table 1). Peak growth occurs in the early stages of rate hikes, while the Fed is merely easing up on the gas; deceleration only ensues in the latter stages, when the Fed pushes down on the brake pedal. Chart 1Rate Hikes Are A Necessary, But Not Sufficient, Recession Condition ... Table 1... And It Takes A While For The Economy To Feel Their Full Effect Index P/E Multiples Don’t Collapse Overnight It’s often said that the Fed hikes rates until something breaks. If equities are ultimately going to break in the process, why wouldn’t a prudent investor read the first rate hike, or even the run-up to it, as a sign to begin reducing exposure? We showed last week that signal measures of economic activity – hiring, lending, spending and GDP – grow well above their through-the-cycle pace while the Fed is tightening policy. Corporate earnings do, too, and S&P 500 earnings expectations have risen most rapidly when the Fed is hiking rates, with Phase I growth nearly doubling aggregate growth (Chart 2, middle panel). Earnings gains are vulnerable to dilution from multiple de-rating, but Phase I multiples have been roughly flat in the aggregate (Chart 2, bottom panel). Perhaps investors recognize that equities don’t break until well after the Fed starts hiking rates, or double-digit earnings growth makes them lose sight of the likelihood that they eventually will. Chart 2Our Definitions Of The Phases Must Be Close To The Mark Based on the empirical record, investors judged by their relative performance should not reduce equity exposure until the rate hiking campaign is well advanced. Phase I has produced the best returns of any phase in the 42 years that earnings expectations have been compiled and missing out on them could be harmful to a professional investor’s career (Chart 2, top panel). Today’s Starting Point Is Unusually Demanding Have equities ever been this expensive at the start of a tightening cycle? History suggests that equities can rally in a “normal” Phase I even after some initial turbulence, but how much scope do they have to rise from current valuation levels? There is unfortunately scarcely any empirical data to address this question. The nine Phase I episodes account for just eight years of the 42-year earnings expectations era and several of them are very short (Table 2). The one instance when forward multiples were at or above today’s levels, from June through October of 1999, they were able to hold their ground, falling less than a half of a multiple point, or 1.5%. Earnings expectations grew by 6.3% over that period, allowing the S&P 500 to advance at the rate of about 1% per month, in line with its overall Phase I performance since 1979. Table 2Multiples Have Held Their Ground In Phase I Empirically, however, robust growth in earnings expectations is the basis for overweighting stocks in Phase I, not multiple expansion. We do not expect re-rating as the Fed pushes the funds rate toward its equilibrium level, and we are alert to the certainty that stocks will de-rate sometime in the future if forward multiples are still subject to mean reversion. History shows it won’t necessarily happen in Phase I, though, and TINA may stave it off while there is a dearth of non-equity options offering positive prospective real returns. Disclaimer (BCA Is Human, Too) How can you be certain that your estimate of the equilibrium rate is accurate? We are not certain at all about the level of the equilibrium rate, and nothing we’ve ever written or said should be construed as implying that we are. As we’ve said many times before, the equilibrium rate is a concept. It cannot be directly observed and our attempts to estimate it are no more than our best effort to gain a sense of where the tipping point for financial markets and the economy might be. Our current 3.25% estimate likely sounds quite high, but we take the estimates at any given point in time with a grain of salt. We are not so full of ourselves that we believe we can pin down an amorphous concept to two decimal places in real time, and we have found that thinking of the point estimate as falling within a plausible range is the best way to proceed. Right now, the US Investment Strategy team views the equilibrium rate as somewhere around 2.5% or higher. That’s all the precision we need to assert with high conviction that monetary policy is accommodative and will remain so for all of 2022 and much, if not all, of 2023. For all the inherent uncertainty of attempts to quantify the equilibrium rate, however, the sharp disparity in equity performance across easy and tight monetary policy settings suggests that we’re on the right track. We’re further encouraged by the clear distinctions in earnings and multiples growth across phases (Figure 1), which suggest that monetary policy settings exert a persistent influence on fundamentals and investor appetites. Given that equities have flourished when policy is easy, overweighting stocks in multi-asset portfolios should contribute to outperformance over the next twelve months. Monetary policy settings are not the be-all and the end-all, but we have found that they offer a very useful default guide to asset allocation. Fooled By Randomness? The results have been robust over a lengthy period, but how do you know they’re not random? Why does the relationship you’ve cited work? We are convinced that the observed strong-growth/tighter-policy, tepid-growth/easier-policy relationship has a durable structural foundation. The through line is the fact that monetary policy is a blunt instrument that works with indeterminate lags. Its limitations influence the way the Fed deploys it and impose a predictable pattern on its economic and market impacts. The Fed is not quite the meddler that its Libertarian-minded critics make it out to be, hovering over the economy in a continuous effort to fine-tune it. Instead, it acts on a limited basis to ensure that the harms embedded in cyclical extremes do not prevent the economy from reaching its long-run potential. It deploys accommodative measures during recessions to keep hysteresis from turning a cyclical soft patch into a structural albatross and restrictive measures during high-revving expansions to keep the inflation genie from getting out of the bottle. The Fed does not want to root out green shoots before they can take hold, so it does not begin Phase I, or assiduously pursue it, until it is certain that the economy can withstand higher rates, especially while (lagging) inflation readings are tame (Chart 3). It therefore launches tightening cycles with a predictable bias to err on the side of being too easy. Chart 3Inflation Is A Lagging Indicator, ... That bias allows the economy to gather momentum in Phase I, in line with cyclical peaks in activity and earnings growth, and outsized equity and credit returns. Left unchecked, the momentum could produce higher inflation, and the Fed is typically compelled to dial up intervention to counter it. Wielding a blunt instrument that works with a lag, however, the Fed is at risk of going too far, and Phase II hikes often induce a recession. Investors sniff out the looming downturn and de-rate equities. By the time the Fed reverses field and initiates a new easing campaign (Phase III), earnings growth has stalled out and measured inflation is peaking (Table 3). Equities mark time and credit spreads widen until, with a slowdown plainly evident and measured inflation sliding, the Fed shifts to full-on accommodation (Phase IV). It maintains market-friendly settings until the economy begins to look too strong, upon which it intervenes to hold it back, kicking off a new policy cycle. Table 3... Managed With Policy That Works With A Lag As we showed last week, the direct relationship between activity and rates is immediately apparent in the real economy. Robust activity translates to robust earnings growth, but it is possible that equity multiples will behave differently in the approaching fed funds rate cycle than they have in the past. Although we expect that TINA will protect equities from meaningful de-rating pressure this year, investors should not lose sight of the fact that the earnings estimate era began with the S&P 500’s forward P/E multiple at 7. That rock-bottom starting point paved the way for an annualized 2.6% valuation increase over the last 42 years, but it cannot continue indefinitely, if at all. We are confident that multiples will continue to fare better when the Fed is cutting rates than when it is hiking them, but the cutting tailwinds will likely weaken going forward, while the hiking headwinds will stiffen. Don’t Believe The Hype Tech stocks are especially vulnerable to higher interest rates and the fate of US indexes is intimately bound up with them. Aren’t you dismissing the threat from higher rates a little too easily? The Tech sector’s outsized presence in the S&P 500 has surely contributed to market anxieties over looming rate hikes. We are firmly of the view, however, that popular concerns over Tech stocks’ interest rate vulnerability are way overdone. The idea that their back-loaded earnings profile makes them acutely vulnerable to a higher discount rate in the manner of long duration bonds ignores the fact that their future cash flows are not fixed. Unlike bonds, their owners' claims on earnings ebb and flow as rates rise and fall in line with economic conditions. Chart 4Relative Tech Multiples Have Mostly Moved With Rates, Not Against Them We recently devoted a Special Report to pushing back against the idea that Tech stocks are hostage to interest rates. In it, we argued that a stock’s price can be viewed as the product of its earnings per share and its P/E ratio. The biggest Tech companies’ earnings have a low interest rate sensitivity because they have little debt and do not sell big-ticket items that their customers have to finance, so the purported inverse relationship between Tech stocks’ relative performance and interest rates must be a function of relative P/E multiple changes. Relative Tech multiples and interest rates consistently moved together in the ten years through 2018, however, and were only sporadically negatively correlated over the last three years (Chart 4). Duration is essential for describing the sensitivity of risk-free bond returns to changes in interest rates, but it is an uncomfortable fit with equities. Treasuries exhibit a nearly perfect inverse correlation with changes in interest rates (Chart 5, top panel), but the cash flow uncertainty introduced by even the modest credit risk associated with investment grade corporate bonds reduces the correlation considerably (Chart 5, second panel). Interest rates’ impact on equities is even more attenuated. The S&P 500 is only weakly – and positively – correlated with rates (Chart 5, third panel), just like its Tech sector constituents (Chart 5, bottom panel).                Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Highlights The most important question is whether the Fed will hike interest rates by more than what is currently discounted in markets, or less. More hikes will trigger a set of cascading reactions. US bond yields will initially jump, boosting the dollar. But this process could also undermine growth stocks, and the US equity market leadership. Equity portfolio flows have been more important in financing the US trade deficit, than Treasury purchases, since 2020. Hence, a reversal in these flows will undermine a key pillar of support for the dollar. On the flip side, less rate hikes will severely unwind higher interest rate expectations in the US vis-a-vis other developed markets, especially in the euro area and Japan. This means we could be witnessing a shift in the dollar, where upside is capped, and downside is substantial. Feature Chart 1The Dollar In 2021 The two most important drivers of the dollar over the last few months have been the spread between US interest rates and other developed markets, as well as the relative performance of US equities (Chart 1). Rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. The outperformance of the US equity market has also coincided with notable portfolio inflows into US equities in 2021. This cocktail of macro drivers has pinned the US dollar in a quandary. If rates rise substantially in the US, and that undermines the US equity market leadership, the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. The Dollar And The Equity Market The traditional relationship between the dollar and the equity market was negative for most of the first half of the pandemic. Monetary easing by the Federal Reserve stimulated global financial conditions setting the stage for an epic bull market. The correlation between the S&P 500 and the DXY index was a near perfect inverse correlation for much of 2020 (Chart 2). Chart 3US Equity Portfolio Inflows Have Been Substantial Since 2020 Chart 2The Dollar In ##br##2020 The big change in 2021 is that this correlation has shifted, as the Fed has pivoted on monetary policy. This means that investors have been betting on higher stock prices in the US, as well as higher interest rates. In short, portfolio flows into US equities have surged (Chart 3). For the long-duration US equity market, higher interest rates could push it to a tipping point, where it starts to underperform other developed market bourses. This will reverse these equity portfolio flows, hurting the dollar in the process. Profits, Interest Rates And The Dollar The key driver of equity markets is profits in the short run, with valuation starting to matter over the longer run. This in turn becomes the key driver of cross-border equity flows. These flows help dictate currency movements. For much of the previous decade, US profits did much better than overseas earnings. For this reason, the US equity market outperformed, pulling the dollar up, as foreign equity purchases accelerated (Chart 4). The post-pandemic era has seen inflation rising across the world, changing the paradigm for US profits. High inflation, and consequently, higher bond yields, have been synonymous with an underperformance of US profits (Chart 5). Banks profit from higher rates, as they benefit from rising net interest margins. Materials, energy, and industrial stocks, benefit from higher inflation via rising commodity prices that boost their pricing power. In a nutshell, rising inflation tends to be better for value stocks and cyclicals, sectors that are underrepresented in the US. This means portfolio flows into US equities, one of the key drivers of the capital account surplus, could be on the cusp of a substantial reversal. Chart 4The Dollar And Relative Profits Chart 5Bond Yields And Relative Profits Second, valuation in the US has become extended as interest rates have fallen. More importantly, US valuations have been more sensitive to changes in interest rates, compared to other developed markets (Chart 6). This is because the US stock market has become increasingly overweight long duration sectors, like technology and healthcare. Higher rates will undermine the valuation premium these sectors command. This will cause the US equity market to derate relative to other cyclical bourses. Chart 6Relative Multiples And Bond Yields The key point is that the US equity market has been the darling of the last decade, and leadership is at risk from higher rates, via a reset in both relative valuation and relative profits. So, while the US market could perform well in 2022, higher rates could undermine its relative performance to overseas bourses. This will curtail equity portfolio inflows, as capital tends to gravitate to markets with higher expected returns. The Dollar And Relative Interest Rates Over the long term, bond flows are the overarching driver of the currency market. Most market participants expect the Fed to be among the most hawkish in 2022. This is clear in the pricing of the Eurodollar versus Euribor December 2022 contract, or just the relative path of two-year US bond yields versus other markets. This in turn has helped drive speculative positioning in the US dollar towards record highs (Chart 7). Correspondingly, US Treasury inflows have accelerated in recent months, even though real interest rates have not risen that much (Chart 8). In level terms, the trade deficit (that hit a record low of -US$80bn in November) is being helped financed by renewed foreign interest in US Treasurys. Chart 8Interest Rates And Treasury Flows Chart 7Record Dollar Speculative Positions We see two major contradictions in the pricing of US interest rates, relative to other developed markets. First, rising inflation is a global phenomenon and not specific to the US. If inflation proves sticky, other central banks will turn a tad more hawkish to defend their policy mandates. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. This will unwind speculative long positions in the dollar. It will also slow portfolio inflows into US Treasuries. Second, the reality is that outside the ECB and the BoJ, most other developed market central banks have already tightened monetary policy ahead of the Fed. The ability of any central bank to tighten policy will depend on the health of the labor market, and the potential for a wage inflation spiral. One data point that has caught our attention is the participation rate across G10 economies - it is notable that the US has one of the lowest participation rates (Chart 9A). Given that many countries have seen their participation rate recover to pre-pandemic levels, it suggests upside in the US rate. This will be especially the case if fiscal stimulus, which could wane, has been a key reason why the US participation rate has stayed low. In a nutshell, the low participation rate in the US could be a reason the Fed lags market expectations for aggressive rate increases this year. On the flip side, a higher participation rate in places like Canada, Norway, and Australia, could allow their central banks to normalize policy faster than the market expects. There has been a loose correlation between relative changes in the participation rate, and relative changes in inflation across G10 economies (Chart 9B).  Chart 9BThe US Relative Participation Rate And Relative Inflation Chart 9AUS Labor Force Participation Is Low, But Improving Finally, relative monetary policy tends to be driven by relative growth. US growth remains robust but has been rolling over relative to other developed markets (Chart 10). This is occurring at a time when China is easing monetary policy, which tends to buffet non-US growth. Higher non-US growth could also tip the bond and currency market narrative that the Fed will tighten much faster than other G10 central banks. Chart 10Non-US Growth Is Improving, Relative To US Growth Conclusion The above analysis suggests we could be entering a paradigm shift in the dollar, where any response by the Fed could eventually trigger the same outcome. Higher rates than the market expects will initially boost the US dollar. But this process will also undermine the US equity market leadership, reversing substantial portfolio inflows in recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US vis-a-vis other developed markets. Our concluding thoughts from our 2022 outlook, which are consistent with our views herein, were as follows: The DXY could touch 98 in the near term but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a currency basket of oil producers versus consumers. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar. The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights The neutral rate of interest in the US is 3%-to-4% in nominal terms or 1%-to-2% in real terms, which is substantially higher than the Fed believes and the market is discounting. The end of the household deleveraging cycle, rising wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand. In addition, deglobalization and population aging are depleting global savings, raising the neutral rate in the process. A higher neutral rate implies that monetary policy is currently more stimulative than widely perceived. This is good news for stocks, as it reduces the near-term odds of a recession. The longer-term risk is that monetary policy will stay too loose for too long, causing the US economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Investors should overweight stocks in 2022 but look to turn more defensive in late 2023. We are taking partial profits on our long December-2022 Brent futures trade, which is up 17.3% since inception. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it.  The Neutral Rate Matters At first glance, the neutral rate of interest – the interest rate consistent with full employment and stable inflation – seems like a concept only an egghead economist would care about. After all, unlike actual interest rates, the neutral rate cannot be observed in real time. The best one can do is deduce it after the fact, something that does not seem very relevant for investment decisions. While this perspective is understandable, it is misguided. The yield on a long-term bond is largely a function of what investors expect short-term rates to be over the life of the bond. Today, investors expect the Fed to raise rates to only 1.75% during this tightening cycle, a far cry from previous peaks in interest rates (Chart 1). Chart 2Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Chart 1Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates     Far from worrying that the Fed will keep rates too low for too long in the face of high inflation, investors are worried that the Fed will tighten too much. This is the main reason why the yield curve has flattened over the past three months and the 20-year/30-year portion of the yield curve has inverted (Chart 2). Secular Stagnation Remains The Consensus View Why are so many investors convinced that the Fed will be unable to raise rates all that much over the next few years? The answer is that most investors have bought into the secular stagnation thesis, which posits that the neutral rate of interest has fallen dramatically over time. The secular stagnation thesis comes in two versions: The first or “strong form” describes an economy that needs a deeply negative – and hence unattainable – nominal interest rate to reach full employment. Japan comes to mind as an example. The country has had near-zero interest rates since the mid-1990s; and yet it continues to suffer from deflation. The second or "weak form" describes the case where a country needs a low, but still positive, interest rate to reach full employment. Such an interest rate is attainable by the central bank, and hence creates a goldilocks outlook for investors where profits return to normal, but asset prices continue to get propped up by an ultra-low discount rate. The “weak form” version of the secular stagnation thesis arguably describes the United States. Post-GFC Deleveraging Pushed Down The Neutral Rate One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If something causes the aggregate demand curve to shift inwards, a lower real interest rate would be required to bring demand back up (Chart 3). Like many other countries, the US experienced a prolonged deleveraging cycle following the Global Financial Crisis. The ratio of household debt-to-GDP has declined by 23 percentage points since 2008. The need for households to repair their balance sheets weighed on spending, thus necessitating a lower interest rate. Admittedly, corporate debt has risen over the past decade, with the result that overall private debt has remained broadly stable as a share of GDP (Chart 4). However, the drag on aggregate demand from declining household debt was not offset by the boost to demand from rising corporate debt. Whereas falling household debt curbed consumer spending, rising corporate debt did little to boost investment spending. This is because most of the additional corporate debt went into financial engineering – including share buybacks and M&A activity – rather than capex. In fact, the average age of the private-sector capital stock has increased from 21 years in 2010 to 23.4 years at present (Chart 5). Chart 4Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Chart 5The Average Age Of Capital Stock Has Been Increasing Buoyant Consumer And Business Spending Will Prop Up The Neutral Rate Today, the US economy finds itself in a far different spot than 12 years ago. Households are borrowing again. Consumer credit rose by $40 billion in November, the largest monthly increase on record, and double the consensus estimate (Chart 6). Banks are easing lending standards across all consumer loan categories (Chart 7). Chart 6Big Jump In Consumer Credit Chart 7Banks Are Easing Lending Standards For All Consumer Loans Chart 8Net Worth Has Soared Over The Past Two Years Meanwhile, years of easy money have pushed up asset prices, a dynamic that was only supercharged by the pandemic. We estimate that household wealth rose by 145% of GDP between the end of 2019 and the end of 2021 – the largest two-year increase on record (Chart 8). A back-of-the-envelope calculation suggests that this increase in wealth could boost aggregate demand by 5%.1 Reacting to the prospect of stronger final demand, businesses are ramping up capex (Chart 9). After moving sideways for two decades, capital goods orders have soared. Surveys of capex intentions remain at elevated levels. Against the backdrop of empty shelves and warehouses, inventory investment should also remain robust. Residential investment will increase (Chart 10). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 10-month high in December. Building permits are 11% above pre-pandemic levels. Amazingly, homebuilders are trading at only 7-times forward earnings. We recommend owning the sector. Chart 9Investment Spending Will Stay Strong Chart 10US Housing Will Remain Well Supported Fiscal Policy: Tighter But Not Tight Chart 11Chinese Credit Impulse Seems To Be Bottoming As in most other countries, the US budget deficit will decline over the next few years, as pandemic-related measures roll off and tax receipts increase on the back of a strengthening economy. Nevertheless, we expect the structural budget deficit to remain 1%-to-2% of GDP larger in the post-pandemic period, following the passage of the infrastructure bill last November and what is likely to be a slimmed down social spending package focusing on green energy, universal pre-kindergarten, and health insurance subsidies. The shift towards structurally more accommodative fiscal policies will play out in most other major economies. In the euro area, spending under the Next Generation EU recovery fund will accelerate later this year, with southern Europe being the primary beneficiary. In Japan, the government has approved a US$315 billion supplementary budget. Matt Gertken, BCA’s Chief Geopolitical Strategist, expects Prime Minister Kishida to pursue a quasi-populist agenda ahead of the upper house election on July 25th.  China is also set to loosen policy. The Ministry of Finance has indicated that it intends to “proactively” support growth in 2022. For its part, the PBoC cut the reserve requirement ratio by 50 basis points on December 6th. The 6-month credit impulse has already turned up (Chart 11). More Than The Sum Of Their Parts Chart 12The Labor Share Typically Rises When Unemployment Falls As discussed above, the end of the deleveraging cycle, rising household wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand in the US. While each of these factors have independently raised the neutral rate of interest, taken together, the impact has been even greater. For example, stronger consumption has undoubtedly incentivized greater investment by firms eager to expand capacity. Strong GDP growth, in turn, has pushed up asset prices, leading to even more spending. Furthermore, a tighter labor market has propped up wage growth, especially among low-wage workers. Historically, labor’s share of overall national income has increased when unemployment has fallen (Chart 12). To the extent that workers spend more of their income than capital owners, a higher labor share raises aggregate demand, thus putting upward pressure on the neutral rate. The Retreat From Globalization Will Push Up The Neutral Rate… Chart 13The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade Globalization lowered the neutral rate of interest both because it shifted the balance of power from workers to businesses; and also because it allowed countries such as the US, which run chronic current account deficits, to import foreign capital rather than relying exclusively on domestic savings.  The era of hyperglobalization has ended, however. The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 13). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. … As Will Population Aging Chart 14Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Aging populations can affect the neutral rate either by dragging down investment demand or by reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 14 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades. In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 15). As baby boomers transition from net savers to net dissavers, national savings will fall, leading to a higher neutral rate. The pandemic has accelerated this trend insomuch as it has caused about 1.2 million workers to retire earlier than they would have otherwise (Chart 16). Chart 16Number Of Retired People Jumped During The Pandemic To What Extent Are Higher Rates Self-Limiting? Some commentators contend that any effort by central banks to bring policy rates towards neutral would reduce aggregate demand by so much that it would undermine the rationale for why the neutral rate had increased in the first place. In particular, they argue that higher rates would drag down asset prices, thus curbing the magnitude of the wealth effect. While there is some truth to this argument, its proponents overstate their case. History suggests that stocks tend to brush off rising bond yields, provided that yields do not rise to prohibitively high levels (Table 1). Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Chart 17The Equity Risk Premium Remains High The last five weeks are a case in point. Both 10-year and 30-year Treasury yields have risen nearly 40 bps since December 3rd. Yet, the S&P 500 has gained 2.7% since then. Keep in mind that the forward earnings yield for US stocks still exceeds the real bond yield by 552 bps, which is quite high by historic standards. The gap between earnings yields and real bond yields is even greater abroad (Chart 17). Thus, stocks have scope to absorb an increase in bond yields without a significant PE multiple contraction. Investment Implications Our analysis suggests that the neutral rate of interest in the US is substantially higher than widely believed. How much higher is difficult to gauge, but our guess is that in real terms, it is between 1% and 2%. This is substantially higher than survey measures of the neutral rate, which peg it at close to 0% in real terms (Chart 18). It is also significantly higher than 10-year and 30-year TIPS yields, which stand at -0.73% and -0.17%, respectively (Chart 19). The neutral rate has also increased in other economies, although not as much as in the US. Chart 18Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Chart 19Long-Term Real Rates Remain Depressed If the neutral rate turns out to be higher than the consensus view, then monetary policy is currently more stimulative than widely perceived. That is good news for stocks, as it would reduce the near-term odds of a recession. Hence, we remain positive on stocks over a 12-month horizon, with a preference for non-US equities. In terms of sector preferences, we maintain our bias for banks over tech. The longer-term risk is that monetary policy will stay too easy, causing the economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Such a day of reckoning could be reached by late 2023. Two Trade Updates We are taking partial profits on our long December-2022 Brent futures trade by cutting our position by 50%. The trade is up 17.3% since inception. Bob Ryan, BCA’s Chief Commodity Strategist, still sees upside for oil prices, so we are keeping the other half of our position for the time being. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it. While the outlook for both companies remains challenging, there is an outside chance that they will find a way to leverage their meme status to create profitable businesses. This makes us inclined to move to the sidelines.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 In line with published estimates, we assume that households spend 5 cents of every one dollar increase in housing wealth, 2 cents of every dollar increase in equity wealth, 10 cents out of bank deposits, and 2 cents out of other assets. Of the 145% of GDP in increased household net worth between the end of 2019 and the end of 2021, 19% stemmed from higher housing wealth, 52% from higher equity wealth, 12% from higher bank deposits, and 17% from other categories.    View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights This week we highlight key charts for US Political Strategy themes and views in the New Year. For H1 2022, we maintain a pro-cyclical, risk-on approach. We favor industrials, energy, infrastructure, and cyclicals. Foreign supply kinks will persist due to Omicron. The US Congress will pass one more spending bill as Democrats try to save their skin ahead of the midterm election. Yet other trends are not so inflationary: Fed rate hikes, an 8% of GDP fiscal drag, and a looming return to congressional gridlock. Midterm elections usually see defensive and growth stocks outperform cyclical and value stocks. This is a risk to our view and may require adjustments later this year. Feature This week we offer our updated US Political Strategy chart pack for the new year. Inflation and stagflation are the top concerns. But the Federal Reserve is kicking into gear, with the market now expecting three-to-four interest rate hikes in 2022 alone. We doubt that will come to pass but it is possible and there is no question that a 12-month core PCE print of 4.7% is forcing the Fed to move. Since the mega-stimulus of March 2020, markets have seen a 91% rally in the S&P 500 and a 114% rally in the tech sector. Ultra-low interest rates and stay-at-home policies created a paradise for tech stocks. But the 10-year Treasury yield surged from 1.45% in December, when Omicron emerged and the Fed turned hawkish, to 1.76% today. An inflation-induced pullback and rotation out of tech stocks was to be expected and has been our most consistent sectoral view. Long-term inflation expectations have not taken off, however. Many investors see secular stagnation over the long run – and even in the short run the resilient dollar should work against inflation. Not only will the Fed wind down asset purchases by $30bn a month starting January 2022 and start hiking rates in March, but also the budget deficit is contracting, making for an 8% of GDP fiscal drag in 2022. In addition the market no longer has any confidence that Congress will pass President Biden’s “Build Back Better” plan. We still think a reconciliation bill will pass, albeit in watered down form. But ultimately the looming midterm election will paralyze Congress, as we argued in our 2022 outlook report, “Gridlock Begins Before The Midterms.” Gridlock will ensure that whatever passes only modestly expands the long-term deficit and then that fiscal taps will be turned off in 2023. In the context of Fed hikes, this should reduce fears of inflation later in 2022, though we still see inflation as a persistent long-term problem. If history is any guide, stocks and bond yields will be flattish for most of the year due to election uncertainty. The difference between this year and other midterm years is that the US consumer is in better financial shape and yet foreign supply kinks will persist due to Omicron. The takeaway is to prefer industrials, energy, small caps, and cyclicals, even though we may not maintain these recommendations for the whole year. We are hedging by staying long health care stocks. Omicron: Less Relevant At Home, More Relevant Abroad American economic growth is declining but will likely settle at or above trend (Chart 1A). Money growth, a proxy for stimulus, is also coming off its peaks while credit growth is rising moderately. The long deleveraging of the American consumer since 2008 appears to have come to an end. But it is too soon to say how aggressively Americans will lever back up and whether a new private sector “debt super cycle” will begin (Chart 1B). Chart 1AEconomic Growth Peaked, Will Slow To Trend Chart 1BEconomic Growth Peaked, Will Slow To Trend The Omicron variant of COVID-19 will have a modest negative impact early in the year. Hospitalizations are picking up in the wake of a surge in new cases following Christmas gatherings. Only 61% of Americans are fully vaccinated and only 23% have received the booster shot that is most effective against Omicron (Chart 2A & Chart 2B). Yet new deaths from the disease remain subdued and only about a fifth of those hospitalized go to the intensive care unit today. Chart 2BCOVID-19 Continues But Relevance Wanes Pharmaceuticals, both vaccines and anti-viral medications, are saving the day and Americans are becoming resigned to the likelihood of getting the virus at some point. Social mobility has dropped off since summer 2021 but will boom in the springtime and consumer confidence is already picking back up (Chart 3A & Chart 3B). The Biden administration is not likely to impose unpopular social restrictions during an election year unless a variant is deadlier, more contagious, and resistant to vaccines, which is not the case with Omicron. Chart 3AOmicron Not A Major Setback For Recovery The resilience of the US will come with persistent inflation in goods given that Omicron will still cause supply disruptions abroad. Not all countries have as effective vaccines when it comes to Omicron – if they maintain tighter social restrictions, prices of imported goods will continue to rise. The Fed cannot resolve foreign bottlenecks. While manufacturing surveys show bottlenecks easing from last year’s highs, foreign supply constraints will remain a problem throughout the year. Chart 3BOmicron Not A Major Setback For Recovery Buy The Rumor, Sell The News Of “Build Back Better” The Biden administration and Democratic Party are still likely to pass one last blast of fiscal spending – the “Build Back Better” budget reconciliation act, a social welfare bill. The output gap is virtually closed and the economy does not need new demand stimulus. However, the Democratic Party needs a legislative win ahead of the midterm election. Thin majorities in both chambers of Congress enable a single senator to derail the bill. But the bill’s provisions are popular among political independents and especially the Democratic Party’s base, which is lacking in enthusiasm about the election as things stand (Charts 4A & 4B). Moderate Democrats in the Senate are still negotiating: their goal is to chop the plan down to size and pass only the most popular provisions, rather than to sink the president and their own party. This means the bill’s top-line spending will be further reduced. The final size should fall from the earlier range of $2.5-$4.7 trillion to $2.3 trillion or less. Add a few tax hikes, like the minimum corporate tax, and the deficit impact will be around $600 billion (Table 1). Table 1"You’ve Gotta Pass It To See What’s In It" Ultimately we cannot have high conviction on the BBB plan because we cannot predict what a single senator will do. That is a matter of intelligence, not macro analysis. But subjectively we still give 65% odds that the Democratic Party will circle the wagons and pass the bill. The party views itself as surrounded by populism on both its right and left flanks – a failure to compromise will whet the appetites of both the Sanderistas (left-wing populists) and the Trumpists (right-wing populists) (Chart 5A). The Republicans still have a better position in the states, and the states have constitutional control of elections, so establishment Democrats are more terrified than usual of flopping in the midterm elections (Chart 5B). Otherwise the midterms – which are already likely to be bad for the Democrats – will deal a devastating blow. Republicans are recovering in party affiliation and tentatively surpassing Democrats among independent voters (Chart 6A). Biden and the Democrats lashed out at former President Trump and the Republican Party on the anniversary of the January 6, 2020 rebellion, but this tactic will not lift their popularity in polls. Their current polling is not much better than that of Republicans in 2018, when the latter suffered a bruising defeat in the midterms (Chart 6B). Chart 6ADemocrats Need A Win Before The Midterm Biden’s legislation would reduce the fiscal drag marginally in fiscal year 2023 but overall the budget deficit will shrink and then lie flat over 2022-24 regardless of what Congress does (Chart 7). New spending would be marginally inflationary over the long run since the budget deficit is expected to expand again beyond fiscal year 2024. Republicans will not be able to slash the budget until they control both Congress and the White House, but in that case they are likely to prove big spenders as in the past. Populism will persist on all sides: the political establishment will keep trying to use fiscal profligacy to peel voters away from populists, who are even more fiscally profligate. Only an inflation-induced recession will restore some fiscal discipline – and that is a way off. Ultimately the significance of the BBB bill is to verify whether establishment politicians – fiscal authorities – are capable of moderating their spending plans according to the threat of inflation, as Modern Monetary Theory maintains. Otherwise the implication is that polarization and populism will produce fiscal overshoots regardless of near-term inflation, even with the narrowest of possible majorities in Congress. The latter, a BBB fiscal overshoot, is what we expect. If it happens it will probably be received negatively by the equity market, fearing faster Fed rate hikes, and it would add credibility to long-term concerns about inflation, because it would reveal that fiscal authorities are not good at adjusting in real time. The former, a BBB failure and a halt to fiscal spending, would suggest that fiscal extravagance remains a crisis-era phenomenon and will be reined in by Congress after a crisis passes, which is probably positive for equities. It would at least suggest that fiscal authorities will adjust when the facts change. Of course, how investors respond to any legislative outcome will depend on a range of factors. But the takeaway is this: Inflation fears may or may not peak in the short run but they will persist over the long run. The Fed: Focus On The Framework In the wake of the Great Recession the Federal Reserve as an institution – both the Federal Open Market Committee and the Board of Governors – shifted in a more accommodative or dovish direction (Chart 8). The shift culminated in the review of monetary policy strategy in August 2020, which produced average inflation targeting. In practice the dovish policy shift is apparent in a real Fed funds rate at -4%, the lowest level since the inflationary 1970s under Fed Chair Arthur Burns. But what is more remarkable is the simultaneous surge in the budget deficit, unlike anything since World War II, and unlike anything in peacetime (Chart 9). Chart 9Inflation And Stagflation Risks The massive increase in federal debt, from 34% of GDP in 2000 to 75% before COVID-19 and 106% today, acts as a constraint on any future Fed hawkishness (Chart 10). A Fed chair who drives interest rates too high amid high debt levels will cause a recession and force the debt-to-GDP ratio up even higher. Yet the result of low rates is to stimulate indebtedness. While the private debt super cycle has subsided, a public debt super cycle is thriving. Chart 10A Major Check On Fed Hawkishness This brings us to today’s predicament. The Fed’s criteria for raising interest rates have mostly been met: 12-month core PCE inflation is running at 4.7% while the inflation breakeven rate in the Treasury market suggests that inflation is well anchored and likely to persist above the 2% inflation target for some time (Chart 11A). The economy is virtually at “maximum employment” (Table 2) – the Fed has set aside concerns about low labor force participation to focus on the collapsing unemployment rate, which is now within the range at which it will feed inflation (Chart 11B). Chart 11AThe Fed's Criteria For Liftoff Table 2The Fed’s Criteria For Liftoff Chart 11BThe Fed's Criteria For Liftoff The takeaway is that the Fed is suddenly restoring the credibility of its 2% inflation target, with headline PCE rapidly coming up on the trajectory established in the wake of the Great Recession (Chart 12), as our US bond strategist Ryan Swift has demonstrated. Chart 12Lo And Behold: Debt Monetization Generates Inflation The explosion of fiscal spending played a critical role in generating this new trajectory. The combination of monetary and fiscal accommodation has worked wonders. Assuming the BBB passes, Chairman Powell will face even greater pressure to prevent this correction of the inflation trajectory from overshooting and turning into a wage-price spiral. The unexpected risk would be if the BBB bill fails, the Fed hikes aggressively, global growth sputters, the dollar surges, and Republicans retake Congress — then Powell may yet see disinflationary challenges in his term in office. Our sense is that the BBB will pass, reinforcing Powell’s less dovish pivot, and yet the Fed’s framework will not permit too hawkish of a stance, resulting in persistent inflation risks over the long run. Three Strategic Themes In our annual strategic outlook, we highlighted three structural or strategic themes that are not beholden to the 12-month forecasting period: 1.   Rise Of Millennials And Generation Z: The sharp drop in labor force participation will gradually mend in the wake of the crisis but the aging of the population ensures that the general trend will decline over time as the dependency ratio rises (Chart 13A). Chart 13AStrategic Theme #1: Rise Of Millennials/Gen Z Politically the millennials and younger generations are gaining clout over time, although their partisan identity will also evolve as they mature and gain a greater stake in the economy and become asset owners (Chart 13B). 2.   Peak Polarization: US political polarization stands at historic highs and will likely remain so over the 2022-24 political cycle (Chart 14A). Polarization coincides with the transformation of society amid falling bond yields and technological revolution (Chart 14B). Chart 14AStrategic Theme #2: Peak Polarization Chart 14BStrategic Theme #2: Peak Polarization The pandemic era has been especially polarized due to the 2020 election and controversies over vaccination (Chart 15). Domestic terrorism of whatever stripe is possible (Chart 16). But any historic incidents will generate a majority opposed to political violence. Chart 16Risk Of Domestic Terrorism True, former President Trump is still likely to run on the Republican ticket, which will ensure that polarization remains elevated (Diagram 1). However, US elections hinge on structural factors, not individuals. Diagram 1GOP 2024 Is Up To Trump So far structural factors point to policy continuity: not only are Democrats still slated to retain the White House, but President Biden has coopted many of Trump’s key policies, including infrastructure, protectionism, and big budget deficits (Chart 17). If Democrats falter, Trump’s policies will be reaffirmed. The implication is that a new national policy consensus is taking shape beneath the surface. 3.   Limited “Big Government”: Americans have been turning away from “small government” and toward “big government” since the 1990s. Voters no longer worry so much about budget discipline and instead look for the “visible hand” of government to support the economy (Charts 18A & 18B). Both domestic populism and geopolitical challenges encourage this shift. Industrial policy and domestic manufacturing are making a comeback (Table 3). Table 3Strategic Theme #3: Limited “Big Government” With extremely robust fiscal policy, the US has avoided the policy mistake of the period after the Global Financial Crisis, when premature fiscal tightening undermined the economic recovery (Chart 19). Policy uncertainty will increase as gridlock returns to Congress and fiscal policy will be frozen. But investors need not fear a slide back into deflation. The Republican Party’s populist base may prevent more Democratic social spending but they will not be able to repeal what is done.  Chart 19Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Three Key Views For 2022 The key views for the 12-month period are connected with the above but of a more short-term or cyclical duration: 1.   From Single-Party Rule To Gridlock: Republicans are highly likely to win back control of the House of Representatives and likely the Senate (Charts 20A & 20B). President Biden’s approval rating suggests that Democrats could lose 40 seats in the House (Chart 21) and three in the Senate (Chart 22), whereas they only need to lose five and one to lose control. Our quantitative Senate election model shows an even split but the model’s trend favors Republicans, as does the political cycle and partisan enthusiasm (Chart 23). 2.   From Legislative To Executive Power: Biden may still pass one more spending bill but otherwise the legislature will be frozen. Democrats will not succeed in ramming legislation through by abolishing the Senate filibuster. Biden will turn to executive decree, where he is already on track to make a historic increase in regulation, which will increase concerns among small business (Chart 24A & Chart 24B). Anti-trust laws are unlikely to be overhauled and Democrats will struggle to bring back the tough anti-trust posture of the 1900s-1950s without new legislation, meaning that Big Tech faces a bigger threat from inflation than regulation (Table 4). The green transition will continue but primarily in the form of any subsidies passed in the reconciliation bill, rather than new taxes or any carbon pricing scheme (Chart 25A & Chart 25B). Chart 24AKey View #2: From Legislative To Executive Power Table 4Key View #2: From Legislative To Executive Power Chart 25BGreen Energy: Subsidies But No Carbon Tax   3.   From Domestic To Foreign Policy Risks: Biden faces a slew of foreign policy and external risks that could damage the Democrats in the midterms. The surge in illegal immigration on the southern border is truly historic and will have significant policy ramifications over the long run (Chart 26A & Chart 26B). The surge in inflation will force Biden to contend with foreign policy challenges with one hand tied behind his back, since energy supply disruptions could derail his party ahead of the midterm election (Chart 27). While Biden could ease some inflationary pressure via reduced trade tariffs, protectionist impulses will prevail during an election year (Chart 28). Chart 26AKey View #3: External Risks For Biden Chart 26BKey View #3: External Risks For Biden Chart 27Foreign Policy Could Hit Prices At Pump Chart 28Tariff Relief In 2022? Don't Bet On It Investment Takeaways The stock market tends to be flat, with risks skewed to the downside, during midterm election years due to policy uncertainty. The same is true for bond yields (Chart 29). Chart 29Stocks And Bond Yields Trend Lower Before Midterms ... When united or single-party governments approach midterms, stocks tend to perform worse than for divided governments in midterm years, while bond yields tend to be a bit higher (Chart 30). This trend is supercharged in 2022 due to the inflationary effects of the pandemic. Chart 30... But United Govts See Higher Bond Yields And Weaker Stocks ... Assuming Republicans regain at least the House, the US will transition from united to divided government (gridlock). In previous such transitions, stocks tend to perform in line with the average for a midterm election year, but bond yields skew higher – reinforcing the previous point (Chart 31). Chart 31... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise We will update our US Sector Political Risk Matrix to bring it better into line with our views, particularly in light of Table 5 below regarding sector relative performance during midterm election years. Normally defensives and growth stocks outperform in midterm years, Table 5ConDisc, Tech, Health Do Best During Midterms …But Waning Pandemic Makes An Exception while cyclicals and value stocks underperform, but 2022 looks to be different due to inflation. Still over the course of the year we would expect the historic trend to reassert itself. Investors should favor cyclicals even though they probably cannot outperform defensives for much longer (Chart 32A). We recommend health care stocks as a hedge given that the dollar should still be resilient this year, Fed hikes should moderate inflation expectations, and midterm policy uncertainty will eventually weigh on risk appetite (Chart 32B). Chart 32AFavor Cyclicals, Though They May Not Outperform Defensives Much Longer Chart 32BLong Health Care As Hedge Value stocks are forming a bottom relative to growth stocks, although this trend is less clear in the US, especially among US large caps, than it is abroad (Chart 33). We favor value over growth on a cyclical basis but midterm election uncertainties will pull the other way, making for a choppy bottom. Chart 33Favor Value And Small Caps, Though Bottom Formation Remains Choppy The same process is visible on a sector basis, where energy and materials continue to outperform tech (Chart 34A). We recommend staying long energy on a cyclical basis, though its outperformance against tech could abate later in 2022. Infrastructure stocks – such as building and construction materials – also continue to outperform. Since Biden’s honeymoon period ended, the outperformance is largely relative to tech rather than the S&P as a whole. We still favor infrastructure stocks as the fiscal policy theme will continue even beyond the current legislation, which will barely start to be implemented in 2022 (Chart 34B). Chart 34AFavor Energy, Materials, And Infrastructure Versus Tech Chart 34BFavor Energy, Materials, And Infrastructure Versus Tech   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

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