Inflation/Deflation

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… Chart II-2B…Account For Most Of The Surge In Deposits   But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… Chart II-3B…Helped Facilitate More Money Creation Last Year   Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output   The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth   Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices   Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The first round of stimulus left US households with $1.5 trillion in excess savings, equivalent to 10% of annual consumption. The stimulus deal Congress reached in December and President Biden’s proposed package would inject an additional $300 billion per month into the economy through the end of September. According to the Congressional Budget Office, the monthly output gap is $80 billion. The true number may be even lower since the CBO’s estimate does not take into account the temporary disruption to the supply side of the economy from the pandemic or the potential disincentive to work from unusually generous unemployment benefits. In and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. The bar for the Fed to raise rates is still very high, which suggests that equities will weather a temporary burst of inflation. Nevertheless, investors should hedge against the risk that inflation will surprise on the upside. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, while banks will benefit from steeper yield curves. The Austerians Give Up In his 2011 State Of The Union Address, President Obama declared that “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” And so the government did. According to calculations by the Brookings Institution, tighter fiscal policy subtracted about 1.2 percentage points from annual GDP growth between 2011 and 2014 (Chart 1). Chart 1US Fiscal Easing Gave Way To Fiscal Drag Soon After The Great Recession   The US was not alone. As Chart 2 illustrates, most advanced economies tightened fiscal policy not long after the Great Recession officially ended. In the case of countries such as Italy and Spain, the tightening came in response to market duress. In other cases such as those involving Germany and the UK, the tightening occurred against the backdrop of fairly low borrowing costs. Chart 2Fiscal Austerity Was The Favored Post-GFC Policy Prescription After the pandemic struck, most governments were quick to loosen fiscal policy again (Chart 3). However, unlike ten years ago, calls for reducing the flow of red ink have been a lot more muted this time around. Chart 3Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis Back in 2010, the OECD – the go-to source for conventional thinking on all economic matters – opined that “monetary policy must be normalized” and that “exit from exceptional fiscal support must start now, or by 2011 at the latest.” Today, the OECD admits that it made a “mistake” in pushing for austerity so soon after the recession ended. “The first lesson is to make sure governments are not tightening in the one to two years following the trough of GDP” explained Laurence Boone, the OECD’s current chief economist, to the FT earlier this month. The OECD’s change of heart partly reflects political reality – assistance for businesses and workers who lost income due to lockdowns is more palatable than bailouts for banks and for homeowners who took on more debt than they could afford. Yet, there is an important economic dimension to the policy pivot as well. The huge spike in bond yields that many pundits predicted a decade ago never materialized. Despite soaring debt levels, real bond yields in the US and most other economies are near record lows (Chart 4). Even the Italian 10-year yield stands at a mere 0.68% now that the ECB has effectively promised to backstop European governments. Chart 4Governments Enjoy Low Borrowing Costs The Bondholder Who Cried Wolf Chart 5Generous Government Transfers Boosted Household Savings After many false alarms, could the inflationistas get the last laugh in 2021? The idea is not entirely far-fetched. Consider the case of the US. Chart 5 shows that US households are sitting on $1.5 trillion of excess savings – equivalent to 10% of annual consumption. The amount of dry powder US households have at their disposal will only get larger. Taken together, the stimulus deal Congress reached in December and President Biden’s proposed fiscal package would inject an average of $300 billion per month into the economy through the end of September. Republicans and centrist Democrats in the Senate may force Biden to winnow down his stimulus plans to something closer to $1 trillion. Nevertheless, this still would provide about $200 billion in incremental monthly support. Official estimates made by the Congressional Budget Office last summer imply that the monthly output gap – the difference between what the economy is capable of producing and what it actually is producing – is currently only $80 billion. In fact, the true output gap may be even lower than this. First, GDP has recovered more rapidly than the CBO had projected. Second, official estimates of the output gap do not control for the fact that part of the economy’s productive capacity – certain retail establishments, hotels, airlines, etc. – has been rendered either fully or partly inoperative due to the pandemic. Third, official estimates also do not account for the fact that generous jobless benefits may have made some workers less eager to find work, thus temporarily raising the natural rate of unemployment. Inflation: Movin’ On Up If the demand for goods and services exceeds supply, prices are likely to go up. How much will they rise? In the near term, inflation is certain to increase from very low levels, if only due to base effects. As my colleague Ryan Swift has noted, both core PCE and core CPI inflation will soon spike above 2% on an annualized basis even if consumer prices rise by a meager 0.15% per month, as the deflationary March and April 2020 data points fall out of the rolling 12-month average (Chart 6). Looking beyond the next few months, the trajectory for inflation will depend on the degree to which the economy overheats. In some categories, there is already evidence of excess demand. US core goods inflation is running at 1.6%, the highest level since 2012. The ISM manufacturing Prices Paid index points to further upside for goods inflation. Soaring commodity prices tell a similar tale (Chart 7). Chart 6Base Effects Will Push Inflation Higher   Chart 7Further Upside For Goods Inflation And Commodity Prices While services inflation has been more downbeat, that could change as the labor market tightens (Chart 8). Housing inflation is also set to bottom. The National Multifamily Housing Council’s Apartment Market Tightness Index remains in contractionary territory. However, the closely-linked Sales Volume Index recently jumped to the highest level in nine years (Chart 9). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, shelter inflation should creep up. Chart 8A Pickup In Services Inflation Is Awaiting A Tighter Labor Market Chart 9Shelter Inflation Could Bottom Soon     A Self-Fulfilling Prophecy? Like most macroeconomic phenomena, inflation is subject to feedback loops. If households expect prices to increase initially but then fall back down once the stimulus has lapsed, they may defer some of their spending until prices return to normal. This could prevent prices from rising in the first place. In contrast, if households expect prices to rise and then keep rising, they may try to expedite their purchases. This would supercharge spending. One can see that there is a self-fulfilling process at work. If households expect prices to remain broadly stable, then they will remain broadly stable. If households expect prices to rise a lot, then they will rise a lot. Imagine last year’s Great Toilet Paper Shortage but on an economy-wide scale. A similar self-fulfilling process works at the firm level. If firms expect prices to rise only briefly, they will try to run down their inventories as quickly as possible to take advantage of temporarily high profit margins. The additional supply will limit any increase in prices. In contrast, if firms expect selling prices to keep rising, they may hoard inventory to take advantage of future higher prices. Likewise, firms may be reluctant to raise wages in response to a temporary overheating of the economy for fear that this would lock in a higher cost structure. In contrast, firms would be more willing to raise wages if they thought that prices would keep rising. Hence, the expectation of rising inflation could trigger a price-wage spiral. Lifting The Anchor The inflationary scenario described above could play out if long-term inflation expectations become unmoored. Central banks have invested a lot of effort in trying to anchor inflation expectations at around 2%. To the extent that they have fallen short of their goal, it is because prices have risen less than desired (Chart 10). Chart 10Central Banks Have Missed Their Inflation Targets To remedy the shortfall in inflation, the Fed has pledged to allow inflation to rise above 2% for a few years, with the aim of bringing the price level back to its long-term target trend. The risk is that such an inflation overshoot happens sooner and is more pronounced than policymakers desire. Christina Romer, the former chair of the Council of Economic Advisers in the Obama administration, famously wrote a paper entitled “It Takes A Regime Shift.” Using the example of Roosevelt’s decision to take the US off the gold standard in 1933, she argued that major monetary policy decisions could permanently jolt inflation expectations. It is too early to say whether the Fed’s new inflation-targeting framework will go down in history as a “regime shift.” What one can say with more confidence is that the rollout of this framework is coming at a tumultuous time. Policymakers and business leaders routinely talk about the “The Great Reset” – the notion that the pandemic provides a once-in-a-lifetime opportunity to shift policy in a new, rather curious, direction. Central bankers better hope that inflation expectations are not reset too much. Investment Implications Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, as highlighted in this week’s report, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The spectre of higher inflation is unsettling to many investors. However, in and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. In the absence of rate hikes, rising inflation would push real rates lower. This would be quite good for stocks, as the experience of the past nine months demonstrates (Chart 11). As noted above, the bar for the Fed to withdraw monetary support is fairly high. This suggests that rising inflation is unlikely to derail the bull market in stocks. Of course, if both actual inflation and inflation expectations were to jump too much, the Fed would have to intervene. With that in mind, investors should position their portfolios to withstand rising inflation. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Chart 11Lower Real Yields Have Lifted Equity Prices Chart 12Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, and would benefit from rising inflation. Banks are also overrepresented in value indices. Chart 12 shows that banks tend to outperform when inflation expectations and long-term bond yields are rising. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Current MacroQuant Model Scores

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Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin Chart 13China Pares Local Government Spending Too Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation Chart 17The Case For US Inflation Chart 18The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China Chart 27No Inflation In China Chart 28No Inflation In China Chart 29No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are ElevatedChart 36Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force Chart 38A Mania In Full Force Chart 39A Mania In Full Force Chart 40A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese StocksChart 45Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks Chart 62The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

特別レポート

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1  Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens Chart 10Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES   Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades