Labor Market
Highlights Duration: Despite last month’s weak employment growth, we continue to expect the economy to reach maximum employment in time for the Fed to lift rates in 2022. Maintain below-benchmark portfolio duration. TIPS: Long-maturity TIPS breakeven inflation rates have returned to levels that are consistent with the Fed’s target. Breakevens are also discounting a very rapid increase in near-term inflation at the front-end of the curve. Investors should take this opportunity to reduce TIPS exposure from overweight to neutral and to close inflation curve flattener and real yield curve steepener positions. Yield Curve: The Treasury curve has transitioned into a bear-flattening/bull-steepening regime beyond the 5-year maturity point, and as such, our recommended yield curve positioning must be re-considered. We recommend that investors position for maximum carry across the yield curve by going long the 5-year bullet and short a duration-matched 2/30 barbell. April Payrolls Shock The Bond Market In the current environment, there is probably nothing more important for US bond investors than keeping a close eye on the monthly employment data. The Federal Reserve has made the first rate hike contingent on a return to “maximum employment”, and bond yield fluctuations reflect the market’s changing assessment of the timing and pace of future Fed rate hikes. Chart 1A Big Miss On Payrolls With that in mind, investors got a shock last Friday when April’s employment report disappointed expectations by one of the widest margins ever. The economy added only 266 thousand jobs to nonfarm payrolls in April while the Bloomberg consensus estimate was calling for 1 million! At present, the market is looking for Fed liftoff in February 2023 (Chart 2). We calculate that monthly employment growth must average at least 412 thousand for the Fed to reach its maximum employment goal by the end of 2022, in time to lift rates in early-2023 (Chart 1 on page 1). Average monthly employment growth of at least 698 thousand is required to hit the Fed’s maximum employment target by the end of this year.1 Chart 2Market Priced For Liftoff In February 2023 The last section of this report (titled “Evidence Of A Labor Shortage In The April Payrolls Report”) explores possible reasons for the weaker-than-expected employment data and concludes that payroll growth will be stronger in the second half of this year. We continue to expect that the economy will reach maximum employment in time for the Fed to lift rates in 2022, and as such, we advise bond investors to maintain below-benchmark portfolio duration. Peak Inflation Last week, we downgraded our allocation to TIPS from overweight to neutral and closed two yield curve positions – an inflation curve flattener and a real yield curve steepener – that had been in place since April 2020.2 We made these moves for two reasons: There is a good chance that realized inflation won’t match the aggressive expectations that are already discounted in the front-end of the inflation curve. Long-maturity TIPS breakeven inflation rates are now consistent with the Fed’s target. In other words, they can’t rise much further without the Fed acting to bring them back down. On the first point, we continue to expect that inflation will be relatively strong between now and the end of the year, but the market has already more than priced-in this outcome. The 1-year CPI swap rate is currently 3.18% and the 2-year CPI swap rate sits at 2.99% (Chart 3). Even if we assume that core CPI increases by a robust +0.2% per month going forward, that will only cause 12-month core CPI inflation to reach 2.29% by the end of this year (Chart 4). Chart 3An Inflation Snapback Is Priced In Chart 4Inflation In 2021 Chart 5TIPS Are Very Expensive To further that point, this week we unveil our new TIPS Breakeven Valuation Indicator (Chart 5). The indicator is based on the theory of adaptive expectations – the theory that inflation expectations are formed based on recent trends in the actual inflation data. In essence, the indicator compares the current 10-year TIPS breakeven inflation rate to different measures of inflation and determines whether 10-year TIPS are currently cheap or expensive relative to 10-year nominal bonds. A negative reading indicates that TIPS are expensive, while a positive reading suggests that TIPS are cheap. At present, the indicator sits at -0.88. Historically, when TIPS are this expensive on our indicator there are strong odds that the 10-year TIPS breakeven inflation rate will fall during the next 12 months (Table 1). Table 1TIPS Breakeven Valuation Indicator Track Record On the second point, we have often noted that a range of 2.3% to 2.5% on long-maturity TIPS breakevens (levels seen during the mid-2000s) is consistent with the Fed’s inflation target. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates haven’t spent much time near those levels during the past decade, but that is starting to change. The 10-year TIPS breakeven inflation rate recently shot up to 2.52%, above the top-end of our target band, while the 5-year/5-year forward TIPS breakeven inflation rate sits near the low-end of the range at 2.34% (Chart 6). Even Fed Chair Powell acknowledged that TIPS breakeven rates are “pretty close to mandate consistent” in the press conference that followed the April FOMC meeting.3 This is not to say that we expect the Fed to pivot quickly towards tightening. However, once the economy reaches maximum employment and the Fed starts to lift rates, the pace of rate hikes will be much quicker if long-maturity TIPS breakeven inflation rates are threatening to break above 2.5%. This puts a long-run ceiling on TIPS breakevens, one that we are quickly approaching. As for our inflation curve flattener and real yield curve steepener positions, neither makes sense unless TIPS breakeven rates continue to rise (Chart 7). Chart 6Long-Maturity Breakevens Are At Target Chart 7Exit Inflation Curve Flattener And Real Yield Curve Steepener The cost of inflation compensation is much more volatile at the front-end of the curve than at the long end, which means that the inflation curve tends to flatten when breakevens rise and steepen when they fall. In other words, the inflation curve will not flatten further unless breakevens move higher. While we don’t see room for further inflation curve flattening, we also think that the curve will remain inverted. With the Fed targeting a temporary overshoot of its 2% inflation target, an inverted inflation curve is much more consistent with the Fed’s stated goals than a positively sloped one. As for the real yield curve, it’s easiest to think of a real yield curve steepener as the combination of a nominal curve steepener and an inflation curve flattener. If the inflation curve holds steady, then there is no difference between a real yield curve steepener and a nominal yield curve steepener. On that note, the next section of this report discusses why the case for a nominal yield curve steepener is also starting to break down. Bottom Line: Long-maturity TIPS breakeven inflation rates have returned to levels that are consistent with the Fed’s target. Breakevens are also discounting a very rapid increase in near-term inflation at the front-end of the curve. Investors should take this opportunity to reduce TIPS exposure from overweight to neutral and to close inflation curve flattener and real yield curve steepener positions. Nominal Treasury Curve: Pick Up Carry In Bullets The average yield on the Bloomberg Barclays Treasury Master Index troughed on August 4th 2020 and rose by 92 basis points until it peaked on April 2nd. The Treasury curve steepened dramatically during that period, with increases in the 10-year and 30-year yields far outpacing the rise in the 5-year yield (Table 2). Table 2Treasury Yield Changes Since The August 2020 Trough But the shape of the yield curve has behaved differently since yields peaked on April 2nd. The average index yield is down 11 bps since then, but the decline has been led by the 5-year while the 10-year and 30-year yields have been relatively sticky. We view this as evidence that, as we edge closer to an eventual rate hike cycle, the yield curve is entering a new regime. This is a natural progression. When rate hikes are only expected to occur far into the future, there will be very little volatility at the front-end of the curve and the yield curve will tend to steepen when yields rise and flatten when they fall. But over time, as we get closer to expected rate hikes, volatility will shift toward shorter and shorter maturities. This will eventually cause the yield curve to flatten when yields rise and steepen when they fall. Chart 8Buy 5-Year Versus 2/30 While there is still very little volatility in 1-3 year yields, it looks like the curve beyond the 5-year maturity point has transitioned into a bear-flattening/bull-steepening regime. That is, when yields rise we should expect the 5/30 slope to flatten and when yields fall we should expect the 5/30 slope to steepen. Indeed, we see that a gap has recently opened up between the trends in the 5/30 slope and the Treasury index yield, while the 2/5 slope remains tightly correlated with the level of yields (Chart 8). The big implication of this regime shift is that we should no longer expect our current recommended yield curve position, long the 5-year bullet and short a duration-matched 2/10 barbell, to perform well in a rising yield environment. To profit from rising yields, investors would be better off positioning for a flatter 5/30 curve by going short the 10-year bullet and long a duration-matched 5/30 barbell. However, this is not the strategy we’d recommend for investors who are already running below-benchmark portfolio duration and are thus already exposed to rising yields. The reason is that while we think the market’s current expected fed funds rate path is slightly too dovish, it is not that far from a reasonable forecast. Put differently, we see bond yields as biased higher but the near-term upside could be limited. For this reason, and since we are already exposed to higher yields through our portfolio duration call, we prefer to enter a yield curve position that will profit from an environment of stable yields. That is, a carry trade that offers a large amount of yield pick-up. The best trade in that regard is a position long the 5-year bullet and short a duration-matched 2/30 barbell (Chart 8, bottom panel). This position offers a positive yield pick-up of 31 bps, a nice cushion against the risk of capital losses from further 2/30 steepening. Bottom Line: The Treasury curve has transitioned into a bear-flattening/bull-steepening regime beyond the 5-year maturity point, and as such, our recommended yield curve positioning must be re-considered. We recommend that investors position for maximum carry across the yield curve by going long the 5-year bullet and short a duration-matched 2/30 barbell. Evidence Of A Labor Shortage In The April Payrolls Report Given the well-founded optimism about the pace of US economic recovery (real GDP grew 6.4% in the first quarter after all) it was very surprising that only 266 thousand jobs were added in April. One possible reason for the weak job growth is that a lack of labor supply is holding it back. We explored this issue in a recent report and concluded that there is a lot of evidence to support the claim.4 While it is a bad idea to read too much into any single datapoint, we think it’s likely that the labor shortage played a significant role in April’s poor employment number. At first blush, the industry breakdown of April’s employment report appears to refute the labor shortage narrative. For example, the Leisure & Hospitality sector added 331 thousand jobs on the month, by far the most of all the industry groups (Table 3). This is interesting because the Leisure & Hospitality sector – primarily restaurants and bars – is a close-contact service industry with low average wages, the exact sort of industry where we would expect to see evidence of a labor shortage. Table 3Employment By Industry But we don’t think strong Leisure & Hospitality job growth refutes the labor shortage narrative. For one thing, while +331k is a lot of new jobs in a single month, it could have been a lot more. The third column of Table 3 shows that the Leisure & Hospitality industry is still 2.8 million jobs short of where it was prior to COVID. Further, other indicators within the Leisure & Hospitality sector clearly point toward a lack of labor supply. The Job Openings Rate is much higher in the Leisure & Hospitality sector than in the economy as a whole (Chart 9) and Leisure & Hospitality wages have grown much more quickly during the past few months (Chart 9, bottom panel). It seems highly likely that Leisure & Hospitality job growth would be stronger if not for supply side constraints. More generally, economy-wide measures of labor demand have recovered much more quickly than the actual employment data (Chart 10). The job openings rate and the NFIB Jobs Hard To Fill survey have both surpassed their pre-COVID peaks, and more households describe jobs as “plentiful” than as “hard to get”. The one outlier is the unemployment rate which, after controlling for furloughed workers, has barely budged off its peak (Chart 10, bottom panel). This points strongly to labor supply being the limiting factor, not demand. Chart 9Leisure & Hospitality Wages Are Accelerating Chart 10Evidence Of A Labor Shortage Bottom Line: There is a lot of evidence that a lack of labor supply is holding back job growth. However, we expect that supply constraints will be cleared up relatively soon as widespread vaccination makes people more comfortable re-entering the labor force, and as expanded unemployment benefits lapse. We expect that job growth will be much stronger in the second half of 2021 and into 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 We define maximum employment as an unemployment rate of 4.5% and a labor force participation rate equal to its pre-COVID level of 63.3%. 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020. 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210428.p… 4 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The modern-day version of the Phillips curve posits that core inflation is determined by long-term inflation expectations and the amount of slack in the economy. In practice, using the Phillips curve to forecast inflation is complicated by uncertainty over: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. While economists should be humble in forecasting inflation trends, the bulk of the evidence suggests that core inflation will remain subdued for the next two-to-three years. However, when inflation eventually does begin to rise, it could happen faster and more forcefully than expected. For the time being, inertia in inflation expectations will allow the Fed and other central banks to maintain a highly accommodative monetary stance. This will keep a lid on bond yields, while fueling further gains in equity prices. Today’s goldilocks environment will give way to a period of stagflation in the second half of the decade, however. The Phillips Curve: Flat… For Now It has become fashionable to criticize the Phillips curve. The reason is understandable: Wild swings in the unemployment rate over the past few decades have failed to translate into meaningful changes in inflation. As we argue in this report, however, it is too early to write off the Phillips curve. Perhaps not today, perhaps not tomorrow, but at some point, it will come roaring back. Investors need to be on guard for when it happens. Conceptually, the modern-day version of the Phillips curve posits that core inflation is a function of long-term inflation expectations and the amount of slack in the economy. Mathematically, it can be written as: Where πt is core inflation at time t, πe is expected long-term inflation, y is GDP, ȳ is the potential (or “full employment”) level of GDP, and α is a parameter specifying how sensitive inflation is to changes in the output gap, yt – ȳt. A positive output gap implies that output is above potential while a negative gap implies output is below potential. The equation reveals three sources of uncertainty about inflation: 1) the true size of the output gap; 2) the degree to which changes in the output gap affect inflation; and 3) the drivers of long-term inflation expectations. Let’s examine all three sources of uncertainty in order to gauge where the balance of risks to inflation lie over the coming months and years. 1. What Is The Current Size Of The Output Gap? Chart 1Prime-Age Employment-To-Population Ratios Remain Below Pre-Pandemic Levels The short answer is that no one knows. The employment-to-population ratio in the OECD for workers between the ages of 25-to-54 was still more than two percentage points below pre-pandemic levels as of the end of last year (Chart 1). The labor market has tightened since then, especially in the US. However, even if US payrolls rise by 1 million in April as per Bloomberg consensus estimates, total employment would still be down 4.7% from January 2020. Admittedly, other data point to a much tighter labor market. US small businesses surveyed by the NFIB have been reporting grave difficulty in finding qualified workers (Chart 2). The job openings rate is at an all-time high, while the quits rate is near pre-pandemic levels (Chart 3). Chart 2US: Temporary Labor Shortage (I) Chart 3US: Temporary Labor Shortage (II) How does one square widespread stories of labor shortages with the fact that total employment remains depressed? A pessimistic interpretation is that the pandemic pushed up structural unemployment. We are skeptical of this thesis. A similar narrative was invoked shortly after the Great Recession to justify tighter fiscal policy and an early start to rate hikes. In the end, not only did the unemployment rate return to pre-GFC levels, but it dropped to a 50-year low. A more plausible explanation is that many service sector workers are currently reluctant to re-enter the labor market due to lingering fears about the pandemic, and in some cases, the need to remain home to look after young children studying remotely. In addition, generous unemployment benefits – which for more than half of US workers exceed their take-home pay – have reduced the incentive to work. Expanded unemployment benefits will expire in September. As the pandemic winds down and schools fully reopen, more workers will rejoin the labor force. Bottom Line: Temporary dislocations are curbing labor supply. However, the level of employment will probably not return to its pre-pandemic trend for another 12 months in the US. It will take even longer to get back to full employment in the euro area and Japan. 2. How Do Changes In The Output Gap Affect Inflation? The Phillips curve was reasonably steep between the mid-1960s and mid-1980s. As such, a falling output gap generally corresponded to rising inflation and vice versa. The result was a series of “clockwise spirals” in inflation-unemployment space, as illustrated in Charts 4A & 4B. Chart 4AThe Phillips Curve Was Steep In The 1960s-1980s Chart 4BThe Phillips Curve Has Been Flat In Recent Decades Starting in the 1990s, the Phillips curve flattened out. By the time of the Great Recession, the slope of the curve was indistinguishable from zero. Will the Phillips curve remain flat? Over the next two years, the answer is probably yes. However, looking beyond then, it is likely to re-steepen again. Chart 5 shows that the “wage version” of the Phillips curve never became very flat. Even after the mid-1980s, there was still a consistently strong negative correlation between wage growth and the unemployment rate. Chart 5The Wage Version Of The Phillips Curve Is Alive And Well Chart 6Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Why, then, did stronger wage growth fail to translate into rising price inflation over the past three decades? To a large extent, the answer is that the Fed began to hike interest rates every time the labor market showed signs of overheating. Higher rates, in turn, led to asset busts. During the 1991 recession, it was the commercial real estate bust; in 2001, it was the dotcom bust; and in 2008, it was the housing bust. All three asset busts led to recessions and higher unemployment before wage growth could seep into inflation. What is different this time is that the Fed is a lot more patient. This means that the economy may eventually overheat to a degree not seen in recent history. How long will that take? Probably a few more years. Consider the case of the 1960s. The unemployment rate was at or below its full employment level for four straight years before inflation took off in 1966 (Chart 6). The shortage of workers spawned a major wage-price spiral. Workers demanded higher wages in response to rising prices, which forced firms to further lift prices in order to defend profit margins. Chart 7US Wage Barometers Disaggregated The US is nowhere near that point now. While some measures of wage growth have accelerated, this mainly reflects a “composition bias” in the way wage indices are constructed. The pandemic led to significant job losses in low-wage sectors such as retail and hospitality, which skewed the calculation of average hourly wages and median weekly earnings to the upside. Cleaner measures of wage growth, such as the Employment Cost Index or the Atlanta Fed Wage Tracker, have been fairly stable over the course of the pandemic1 (Chart 7). Bottom Line: There is good reason to think that the Phillips curve is “kinked”, meaning that inflation might not rise much until the labor market has severely overheated. For now, no major economy is near the kink. 3. Will Long-Term Inflation Expectations Stay Well Anchored? One of the distinguishing features of the clockwise spirals in Chart 4 is that they trace out a series of “higher highs” and “higher lows” for inflation during the period between the mid-1960 and early-1980s. In essence, what happened back then was that inflation would rise, prompting the Fed to step on the brakes ever so gingerly. Inflation would then decline modestly, but not by enough to bring it back to its original level. The “stickiness” of inflation during that era highlights the importance of inflation expectations. In the context of the Phillips curve, a change in long-term inflation expectations could, at least theoretically, affect realized inflation independent of what happens to the output gap. In practice, however, the size of the output gap is likely to influence inflation expectations and vice versa. A persistently positive output gap will cause inflation to consistently exceed its long-term expected value. As Milton Friedman and Edmund Phelps pointed out more than four decades ago, this will eventually prompt businesses and the public to revise up their expectations of inflation. Unless the central bank lifts interest rates by enough, a rise in inflation expectations could spur people to increase spending in advance of higher prices. This could cause the economy to further overheat, leading to even higher inflation expectations. In other words, a positive output gap could lead to higher inflation expectations, and higher inflation expectations, in turn, could push aggregate demand even further above potential. Suppose that people jettison the expectation of a stable long-term inflation rate and adopt an “adaptive” approach whereby they assume that inflation this year simply will be what it was last year. This is equivalent to replacing πe in the Phillips curve equation with πt-1, yielding: This is the “accelerationist” version of the Phillips curve. It says that the output gap determines the change in inflation rather than the level of inflation. With an accelerationist Phillips curve, inflation can increase without bound if the central bank tries to keep output above its potential level. The transition to an accelerationist Phillips curve appears to have happened in the 1970s. As my colleague Jonathan Laberge has argued, and as recent empirical work has emphasized, changes in inflation expectations generally have a larger impact on realized inflation than changes in the output gap. In particular, it is difficult to explain the Volcker disinflation solely based on the movement in the unemployment rate. Inflation continued to fall even after the unemployment rate peaked in December 1982. The surprising decline in inflation following the recession even prompted two young economists working at the Council of Economic Advisors, Paul Krugman and Larry Summers, to pen a memo entitled “The Inflation Timebomb?” in which they predicted a “significant reacceleration of inflation in the near future”. Chart 8Long-Term Inflation Expectations Remain Well Anchored Today Why did inflation keep falling in the 1980s as the economy recovered? A plausible theory is that Paul Volcker’s appointment to Fed chair marked a “regime shift” in the conduct of monetary policy. No longer would the Fed stand idly by as inflation galloped higher. Even if it took double digit interest rates and a deep recession, the Fed would do what was needed to break the back of inflation. This allowed the accelerationist Phillips curve of the 1970s to transition to its modern-day version characterized by low and stable inflation expectations. What does all this mean for today? Both survey and market-based measures of long-term inflation expectations remain well anchored (Chart 8). Given that inflation expectations have been low and stable for the past few decades, it may take even more overheating than what occurred in the 1960s to unmoor them. Such an unmooring of inflation expectations is not impossible, however. The Fed seems eager to overheat the economy. Fiscal policy is likely to remain highly accommodative long after the pandemic restrictions ease. Meanwhile, as we discussed in an earlier report, many of the structural factors that have suppressed inflation could go into reverse. Bottom Line: Inflation expectations are likely to remain well anchored for the next two years. However, they could become unmoored later on if monetary and fiscal policy remain highly accommodative. Concluding Thoughts There is a lot of concern over inflation these days. We would fade these concerns, at least for the time being. The much-discussed spike in manufacturing input prices is nothing new. The exact same thing happened in 2008 and 2011 (Chart 9). Pundits who hyperventilated about soaring inflation were proven wrong back then and they are likely to be proven wrong again this year. Chart 9Wholesale Inflation Rose (Briefly) In 2008 And 2011 Too Chart 10The Most Refined Measures Of Core Inflation Paint A Benign Picture The pandemic distorted prices in all sorts of unprecedented ways. This means that looking at standard measures of core inflation may be misleading. It is much better to consider more refined measures of core inflation that go beyond simply stripping out the effects of volatile food and energy prices. Chart 10 shows that trimmed-mean inflation, median price inflation, and sticky price inflation all suggest that underlying inflation remains well contained. Continued low inflation will allow the Fed to maintain a highly accommodative monetary policy. This will keep a lid on bond yields, while fueling further gains in equity prices. When will it be time to worry? When the labor market starts to overheat to the point that a wage-price spiral erupts. As discussed above, that is not a near-term risk. However, such a spiral could occur in two-to-three years, setting the stage for a period of stagflation in the second half of the decade. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Duration: Foreign inflows and dollar strength may give us a reason to turn bullish on US bonds at some point in the future, but not yet. For now, investor sentiment toward the dollar is more consistent with rising US bond yields than falling US bond yields. Maintain below-benchmark portfolio duration. Municipal Bonds: The economic and policy back-drop is favorable for municipal bonds, but value is not universally attractive. Investors should favor long maturity General Obligation and Revenue bonds over investment grade corporates with the same credit rating and duration. Investors should also overweight taxable municipal bonds versus investment grade corporate credit. High-Yield Munis are fairly valued relative to High-Yield corporates. Economy: The US economy is currently suffering from a shortage of labor. That is, job openings are unusually high given the current unemployment rate. Feature The recent pullback in US bond yields continues to confound commentators. As we noted in last week’s report, the 10-year Treasury yield’s 8 basis point drop on April 15th occurred on a day when the US economic data surprised to the upside.1 Since then, bond yields have held steady even as the trend toward stronger economic data has persisted. Our explanation for the divergence between bond yields and the economic data is that the yield curve had already discounted a rapid economic recovery and the incoming data are simply confirming that narrative. But many alternative explanations have also been put forth to explain the drop in yields. One of those explanations is that the attractiveness of US bonds to foreign investors has resulted in a wave of foreign buying that has pushed US yields lower. Our view is that foreign interest might become a reason to turn bullish on bonds at some point, but it is not currently a meaningful factor weighing on US yields. Foreign Inflows Are Not To Blame For Falling US Bond Yields Chart 1 illustrates that US bond yields are significantly higher than yields in Germany and Japan (two of the other major developed bond markets), a dynamic that has been in place since 2013. However, US yields have both risen and fallen at different times since 2013, so the fact that they are higher than yields in Germany and Japan is not a sufficient reason to expect that foreign inflows will push US bond yields lower. One potential problem with Chart 1 is that it shows local currency bond yields. That is, if a German investor buys a 10-year US Treasury note today with a plan to sell it in three months, he is exposed to both the risk that the 10-year US yield will rise during the next three months and to the risk that the US dollar will depreciate against the euro. For this reason, many global fixed income investors choose to hedge the currency risk in their portfolios, an action that significantly alters the attractiveness of foreign bonds. The second and third panels of Chart 2 show the yield advantage in the 10-year US Treasury note compared to the 10-year German bund and 10-year JGB, respectively, after hedging all yields into a common currency. We assume a 3-month investment horizon. The message is that US yields are still highly attractive to foreign investors, even after the currency risk is hedged. Chart 1Higher Yields In US Bonds Chart 2Dollar Sentiment Supports Higher Yields In common-currency terms, German investors can pick up an extra 108 bps in the 10-year US Treasury note compared to the 10-year German bund, about the same amount of extra compensation that was available in 2014 and 2003 (Chart 2, panel 2). Japanese investors can pick-up even more extra compensation (115 bps) by moving out of 10-year JGBs and into US Treasuries, though US Treasuries looked even more attractive relative to JGBs in 2014 and 2003 (Chart 2, panel 3). Whether they hedge currency risk or not, there’s no doubt that foreign investors can gain a significant yield pick-up by moving into the US bond market. The more important question, however, is whether these international yield spreads tell us anything about the future direction of US bond yields. To answer that question, we look at two other periods when US yields were very attractive to foreign investors: 2003 and 2014. Hedged US yields were elevated in 2003, but the US dollar was also near the beginning of a multi-year bear market (Chart 2, panel 4) and investor sentiment toward the US dollar was deeply bearish (Chart 2, bottom panel). In that environment, the 10-year US Treasury yield moved higher for several years, despite its attractiveness to foreign investors. The opposite occurred in 2014. US bonds once again offered an attractive yield pick-up to foreign investors, but this time the US dollar was near the beginning of a bull run (Chart 2, panel 4) and investor sentiment was tilted in favor of a stronger dollar (Chart 2, bottom panel). The result is that US bond yields fell, aided by greater foreign demand. Looking at the contrast between 2003 and 2014, it is clear the spread between US yields and foreign yields is much less predictive of future bond moves than the path of the US dollar and investor sentiment toward the dollar. At present, with dollar sentiment deep into bearish territory (Chart 2, bottom panel), it is unlikely that foreign demand is weighing on US bond yields in any meaningful way. Bottom Line: Foreign inflows and dollar strength may give us a reason to turn bullish on US bonds at some point in the future, but not yet. For now, investor sentiment toward the dollar is more consistent with rising US bond yields than falling US bond yields. Maintain below-benchmark portfolio duration. Municipal Bonds: Better Than Credit The performance of municipal bonds since US Treasury yields troughed last August has been truly remarkable (Table 1). The Bloomberg Barclays Municipal Bond Index has returned +2.02% while comparable Treasury and Credit indexes booked losses. The outperformance has extended into Taxable Munis, where returns have been less negative than in Aa-rated Credit, and to High-Yield Munis which have outperformed their corporate counterparts. Table 1Total Returns Since The Bottom In Treasury Yields Two main factors are responsible for the outperformance of municipal bonds. First, state & local government tax revenues recovered much more quickly than many anticipated at this time last year. In fact, they have already taken out their pre-COVID highs and are growing at a pace of 5.25% per year (Chart 3). Second, the federal government stepped in and delivered $350 billion of funding (~1.6% of GDP) to state & local governments as part of the recently enacted American Rescue Plan. This support comes on top of the spike in Federal Grants-In-Aid that resulted from the passage of last year’s CARES act (Chart 3, panel 3). It’s certainly true that state & local governments also faced incredibly high expenses last year as they battled the pandemic, yet they still managed to eke out positive net savings in 2020 as a whole (Chart 3, bottom panel). Chart 3S&L Government Balance Sheets Healing Quickly The outlook for state & local government balance sheets will continue to brighten as the rapid economic recovery pushes up tax revenues and the American Rescue Plan’s transfers are doled out. This will support municipal bond returns. What’s more, President Biden’s recently announced plan to increase the income tax rate on high income individuals could bolster municipal bond performance. Granted, there is no guarantee that this proposed tax change will occur. The President will include the income tax hike in the American Families Plan, a proposal that will not hit the legislative agenda until 2022 as the government concentrates on passing the infrastructure-focused American Jobs Plan this year. There is a good chance that there won’t be enough time to pass the American Families Plan before the 2022 midterm election, after which the composition of Congress could change. Our US Political Strategy service puts the odds of the American Families Plan passing before the 2022 midterm at 50/50.2 Nevertheless, the mere threat of higher income taxes might be all it takes to drive interest toward tax-exempt municipal bonds. All in all, we see the President’s rhetoric as providing a tailwind to muni returns. Clearly, our view is that the economic landscape is positive for municipal bond performance. But value has deteriorated markedly in some parts of the sector, and investors need to be selective. The rest of this section considers where the most attractive municipal bond opportunities lie. Aaa Munis Versus Treasuries Investors should shy away from Aaa-rated municipal bonds. Aaa-rated Muni / Treasury yield ratios have already collapsed, particularly at the long-end of the curve (Chart 4). As is the case in corporate credit, investors need to move down the quality spectrum to find compelling opportunities. Chart 4Aaa Muni / Treasury Yield Ratios Investment Grade Munis Versus Credit Some of those compelling opportunities can be found in lower-rated investment grade municipals, particularly relative to investment grade credit. If we match the credit rating and duration between the Bloomberg Barclays General Obligation (GO) Municipal Index and the Bloomberg Barclays Credit Index, we find that long-maturity GOs look very attractive (Chart 5). Investors facing a tax rate of 2% or higher receive a greater after-tax yield in GO Munis than in Credit at the very long-end of the curve (17+ years to maturity). GO Munis in the 12-17 year maturity bucket also look attractive relative to Credit, with a breakeven tax rate of 10%. The after-tax yield pick-up in GO Munis is less favorable in the belly of the curve. Investors in the 8-12 year maturity bucket face a breakeven tax rate of 28% and those in the 6-8 year maturity bucket face a breakeven tax rate of 39%. Revenue bonds offer better value than GOs. In fact, revenue Munis with maturities above 12 years offer a before-tax yield pick-up compared to Credit with the same credit rating and duration (Chart 6). Even at shorter maturities, the breakeven tax rate for revenue bonds versus Credit is fairly attractive. Investors in the 6-8 year maturity bucket face a breakeven tax rate of 28% and those in the 8-12 year maturity bucket face a breakeven tax rate of 18% Chart 5GO Munis Versus Credit Chart 6Revenue Munis Versus Credit Taxable Munis Chart 7Taxable Muni Spread Versus Credit Rating And Duration Matched Credit Even though they won’t benefit from any upcoming changes to the tax code, taxable municipal bonds are an attractively priced alternative to investment grade Credit (Chart 7). After matching the duration and credit rating, the Bloomberg Barclays Taxable Municipal Index offers a yield pick-up of 43 bps versus investment grade Credit. Shorter maturities offer a yield pick-up of 30 bps and longer maturities offer 55 bps. These seem like yield premiums worth grabbing given the favorable economic environment for state & local government balance sheets. High-Yield Munis Chart 8High-Yield Munis Versus Corporates Finally, we look at high-yield municipal bonds and find that they are fairly valued compared to high-yield corporate bonds. The High-Yield Municipal Index offers a yield that is only 88 bps below that of the credit rating and duration matched High-Yield Corporate Index, which is relatively high compared to recent years (Chart 8). That 88 bps yield differential translates to a breakeven tax rate of 21%. That is, any investor facing a tax rate above 21% will get a greater after-tax yield in high-yield Munis than in high-yield corporates. While the yield spread is reasonably attractive, it’s important to note that the High-Yield Municipal Index is extremely negatively convex (Chart 8, bottom panel) and thus prone to extension risk if bond yields rise. This means that the appearance of attractive relative value in high-yield Munis will quickly evaporate as bond yields rise and muni yields start getting compared to a longer-duration benchmark. All in all, we judge value in high-yield Munis to be neutral relative to high-yield corporates. Bottom Line: The economic and policy back-drop is favorable for municipal bonds, but value is not universally attractive. Investors should favor long maturity General Obligation and Revenue bonds over investment grade corporates with the same credit rating and duration. Investors should also overweight taxable municipal bonds versus investment grade corporate credit. High-Yield Munis are fairly valued relative to High-Yield corporates. Economy: The Labor Shortage Won't Last Chart 9Help Wanted! An interesting recent economic development has been increased concern about the availability of labor. The Fed’s April 2021 Beige Book noted that “hiring remained a widespread challenge” and the number of small businesses having difficulty filling vacancies has spiked (Chart 9). This seems odd given that the economy is still missing 8.4 million jobs compared to February 2020. So what exactly is going on? The Beveridge Curve – the relationship between job openings and the unemployment rate – is the classic way to track shifts in structural unemployment (Chart 10). Notice that the curve has shifted sharply to the right during the past few months. This confirms the anecdotes from the Beige Book and the NFIB survey. There are, in fact, significantly more available jobs for the same unemployment rate. Chart 10The Beveridge Curve If this rightward shift in the Beveridge Curve proves to be permanent, it would mean that the natural rate of unemployment is higher than we thought and that we should expect wage-driven inflationary pressures to emerge earlier in the recovery. However, we suspect that the recent rightward shift in the Beveridge Curve is not permanent and that it will move back toward more normal levels as COVID’s impact subsides. We see two possible reasons for the Beveridge Curve’s rightward shift. First, the combination of expanded unemployment benefits and stimulus checks on offer from the federal government may be discouraging people from going back to work, even as jobs become available. To the extent that this is a factor holding back job growth, it will soon subside. The last of the COVID stimulus checks are currently being delivered and expanded unemployment benefits will expire in September. Second, there are many other COVID-related reasons why people may be reluctant to go back to work. They could fear getting sick or may have increased responsibilities at home due to school or daycare closures. These factors too will eventually subside as the nation reaches herd immunity and slowly returns to normal. An industry breakdown of job openings provides some evidence that the rightward shift in the Beveridge Curve will prove transitory. Chart 11A shows that the ‘Leisure & Hospitality’ and ‘Education & Healthcare’ sectors have the highest rates of job openings, and Chart 11B shows that they have both seen large increases in job openings since the pandemic began. This tells us that the increase in job openings has been concentrated in those sectors most impacted by the pandemic. It stands to reason that the dynamic will reverse as COVID becomes less of a concern. Chart 11AJob Openings Rate By Industry Chart 11BChange In Job Openings Rate By Industry For bond investors, it’s worth noting that the current labor shortage means that the downward trend in the unemployment rate will not immediately be offset by a rapidly rising labor force participation rate. That is, we could see the unemployment rate reach the Fed’s target range relatively soon, but with a labor force participation rate that is well below pre-COVID levels (Chart 12). Fortunately, the Fed has told us that it wants to see both 3.5% - 4.5% unemployment and a return to pre-COVID participation rates before it will lift interest rates. Chart 12Fed Targets Both The Unemployment Rate And The Part Rate In other words, the Fed also believes that the rightward shift in the Beveridge Curve will be transitory and it will not rush to tighten policy if the labor force participation rate remains low. Our own expectation is that labor shortage issues will be resolved by next year and that the Fed will be comfortable lifting rates before the end of 2022.3 Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021, available at usbs.bcaresearch.com 2 Please see US Political Strategy Weekly Report, “Biden’s Pittsburgh Speech And Legislative Agenda”, dated April 1, 2021, available at usps.bcaresearch.com 3 For more details on our outlook for Fed policy please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights After staging a tentative rebound in the first three months of the year, the US dollar has resumed its weakening trend. We expect the greenback to drift lower over the next 12 months, as global growth momentum rotates from the US to the rest of the world, the Fed maintains its ultra-accommodative monetary stance, and the US struggles to finance its burgeoning trade deficit. China will provide adequate fiscal and monetary support for its economy, which will buoy commodity prices, the yuan, and other EM currencies. The Canadian dollar should strengthen as the Bank of Canada continues to shrink its balance sheet with the goal of lifting rates by the end of 2022. EUR/USD is on track to rise to 1.25 by year-end. The pound will strengthen against the euro. While the yen’s defensive nature will limit any gains in the currency, a cheap valuation and relatively high Japanese real rates will keep downside risks in check. Global Growth Momentum To Rotate From The US To The Rest Of The World Sizable upward revisions to US growth projections gave the US dollar a modest boost in the first quarter of 2021 (Chart 1). According to Bloomberg consensus estimates, US real GDP grew by 5.4% in the first quarter, spurred on by massive fiscal stimulus and a speedy vaccination rollout. In contrast, real GDP in the euro area, the UK, and Japan contracted (Table 1). Chart 1A Dovish Fed Kept The Dollar From Strengthening Much This Year Despite Strong US Growth Vis-À-Vis The Rest Of The World Table 1Growth In Major Advanced Countries Is Expected To Start Catching Up To The US Later This Year While economic momentum still favors the US in the second quarter, the gap with other countries will narrow dramatically. The US economy is on track to expand by 8.1% in the current quarter. Bloomberg consensus expects the euro area to grow by 7.4%, the UK by 17.4%, and Japan by 4.7%. Looking out to the third quarter, both the euro area and the UK are poised to grow faster than the US. Continental Europe, in particular, should see much stronger growth in the second half of 2021 following a sluggish start to the vaccine rollout. Enough Vaccines For All? The vaccination campaign has gotten off to a slow start in most emerging markets. The spread of more contagious Covid-19 variants has led to a surge in infections in some regions. Notably, India is reporting over 300,000 new cases a day. Matters should improve on the pandemic front for many developing economies later this year. Assuming that vaccine makers are able to achieve their production targets, the Duke University Global Health Innovation Center estimates that 12 billion vaccine doses will be produced in 2021. This would be enough to vaccinate 75% of the world’s population, close to most measures of “herd immunity.” China Will Maintain Ample Policy Support Chart 2Real Rate Differentials Moved In Favor Of The Dollar At The Long End Of The Curve In Q1, But Not At The Short End Investor concerns that the Chinese authorities are about to reverse stimulus measures are overblown. Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to average 8% of GDP in 2021, largely unchanged from 2020 levels. She sees credit growth falling from 15% in 2020 to 12% this year (in line with her estimate of nominal GDP growth). Given that China’s debt-to-GDP ratio stands at 270%, credit growth of 12% would leave the outstanding stock of credit roughly 33 trillion yuan (32% of GDP) higher at the end of 2021 compared to end-2020. That is a lot of new credit formation, all of which should buoy commodity prices, the yuan, and other EM currencies. Rate Differentials Remain Dollar Bearish Despite strong US growth, US 2-year real rates have continued to decline in relation to rates abroad. Long-term yield differentials did rise in favor of the US in the first three months of the year, giving the dollar a lift. However, long-term differentials have since reversed course, which helps account for the dollar’s renewed weakness (Chart 2). The Fed’s dovish stance explains why stronger growth has given so little support to the dollar. The 10-year Treasury yield generally tracks the expected Fed funds rate two-to-three years out (Chart 3). At present, the markets are as hawkish relative to the median Fed dot as they have ever been (Chart 4). Chart 3Bond Yields Are Unlikely To Rise Much Unless The Market Lifts Its Estimate Of Where The Fed Funds Rate Will Be 2-To-3 Years Out Chart 4The Market Is Very Hawkish Relative To The Fed Dots This doesn’t mean that market expectations cannot get more hawkish from here. However, for this to happen, the Fed would need to start aggressively talking up the prospect of tapering asset purchases and accelerating the timeline to hiking rates. This does not seem probable to us. Chart 5Prime-Age Employment Remains Well Below Pre-Pandemic Levels The prime-age employment-to-population ratio is still 3.7 percentage points below pre-pandemic levels (Chart 5). Overall US employment is about 5% below where it was in January 2020. Among workers earning less than $20 per hour, employment is down more than 10% (Chart 6). While some firms have complained about a shortage of workers, this likely reflects the combination of generous unemployment benefits (which expire in September) and lingering fears about catching the virus from work (which will abate as more people are vaccinated). Just as was the case following the Great Recession – when market commentary was rife with talk about a permanent increase in “structural unemployment” – concerns that the pandemic has led to lasting labor market damage will prove to be largely unfounded. Chart 6US Employment Still Down About 5% From Its Pre-Pandemic Levels The Dollar Faces Balance Of Payments Pressures The dollar is not a cheap currency. It is 13% overvalued based on Purchasing Power Parity exchange rates (Chart 7). One of the consequences of the dollar’s overvaluation has been a persistent trade deficit. As Chart 8 shows, the US trade deficit in goods and services has widened sharply since early 2020. Chart 7The Dollar Is Expensive Based On Its PPP Fair Value Chart 8The Widening US Trade Deficit Excessively large budget deficits drain national savings, leading to a larger current account deficit. Hence, the dollar has usually weakened whenever the government has eased fiscal policy beyond what was necessary to close the output gap (Chart 9). Foreigners have been net sellers of Treasurys this year. To a large extent, equity inflows have supported the dollar (Chart 10). However, if growth rotates from the US to the rest of the world, non-US stock markets are likely to outperform. This could cause foreign equity inflows into the US to turn into outflows. The dollar would then need to weaken to make US stocks more attractive in foreign-currency terms. Chart 9The Dollar Usually Weakens Whenever The Government Eases Fiscal Policy Beyond What Is Necessary To Close The Output Gap Chart 10Equity Inflows Supported The Dollar This Year Technicals Point To A Weaker Dollar For many investment decisions, being a contrarian is a smart strategy. This does not apply to trading the US dollar, however. The dollar is a high momentum currency (Chart 11). When it comes to the dollar, you want to be a trend follower. Chart 11The Dollar Is A High Momentum Currency Chart 12 shows that a simple trading rule that bought the dollar index when it was trading above its moving average would have made money, whereas a rule that bought the index when it was below its moving average would have lost money. While trading rules using short-term moving averages work best, even long-term moving average rules yield profitable results. Chart 12ATrading The Dollar: Follow Momentum (I) Chart 12BTrading The Dollar: Follow Momentum (II) Today, the dollar is trading below all of its various moving averages, which points to further downside for the currency. The dollar’s momentum status extends to sentiment. In general, the dollar is more likely to strengthen when sentiment is already bullish. On the flipside, the dollar is more likely to weaken when sentiment is bearish. At present, dollar sentiment is bearish, which increases the odds of further dollar weakness (Chart 13). Chart 13ABeing A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Chart 13BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Chart 14Seasonality In The FX, Bond, And Equity Markets Finally, the dollar has tended to exhibit seasonal fluctuations. In general, the greenback has strengthened in the first half of the year and weakened in the second half (Chart 14). It is not entirely clear what explains this phenomenon, but it is worth noting that since 1985, almost all of the cumulative decline in Treasury yields has occurred in the back half of the year. Cyclical Currencies Are Most Likely To Strengthen Against The US Dollar Cyclical (i.e., high-beta) currencies will fare best against the US dollar over the next 12 months. In the EM space, strong global growth will benefit the Mexican peso, Chilean peso, Brazilian real, South African rand, Korean won, and the Indonesian rupiah. In the developed economy sphere, the Swedish krona, Norwegian krone, and Australian and Canadian dollars are poised to appreciate the most. We are particularly bullish on the loonie. The Bank of Canada announced on Wednesday that it will reduce the weekly pace of government bond purchases from C$4 billion to C$3 billion. Even before this announcement, the BoC’s balance sheet was shrinking following the decision to scale back repo operations and discontinue several other asset purchase programs. The BoC also indicated that it expects the Canadian economy to return to full employment in the second half of 2022, which should set the stage for the first rate hike by the end of next year. We expect EUR/USD to reach 1.25 by year-end. The British pound will strengthen to 1.50 against the dollar and 1.20 against the euro. Chart 15 shows that GBP/USD has closely tracked the rise and fall of global equities. Notably, the pound is 15% undervalued against the euro based on real 2-year interest rate differentials (Chart 16). Chart 15GBP/USD Has Closely Tracked Global Equities Chart 16The Pound Is Undervalued Against The Euro Based On Real Short-Term Interest Rate Differentials The Japanese yen is a highly defensive currency. Hence, stronger global growth will pose a headwind to the yen. Nevertheless, the yen is quite cheap, trading at a 20% discount to its Purchasing Power Parity exchange rate (Chart 17). Moreover, real yields are higher in Japan than they are in the other major economies, reflecting ongoing deflationary pressures (Chart 18). On balance, we expect the yen to move sideways against the US dollar over the next 12 months. Chart 17The Yen Is Quite Cheap Chart 18Real Yields Are Higher In Japan Than In The Other Major Economies Equity Implications Of A Weaker Dollar Cyclical stocks tend to outperform defensives when the dollar is weakening. To the extent that cyclicals are overrepresented in stock market indices outside the US, a weaker dollar favors non-US equities (Chart 19). Chart 19Cyclical Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 20Value Stocks Generally Do Best In A Weak Dollar Environment Value stocks also tend to do best in a weak dollar environment (Chart 20). As such, we recommend that investors overweight cyclicals, non-US, and value stocks over the next 12 months. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
ハイライト
米国の成長アウトパフォーマンスが弱まりつつある暫定的な兆候が見られる。
海外の製造業セクターの回復が既に米国から主導権を奪っている。このトレンドは間もなくサービスセクターへと回転するだろう。
したがって、長期投資家はユーロの下落時に買い増しを始めるべきである。
カナダ経済は2月時点の評価よりも速いペースで改善している。
これはCADが早期にアウトパフォームする可能性を示唆している。
特集
チャート I-1
ユーロがDXYを牽引する
相対的成長、ユーロ、そしてルーニー
相対的成長、ユーロ、そしてルーニー
米国経済は今年、成長のアウトパフォーマーとなっている。そのため米国では利回りの上昇がより速く進み、ドルが買われている。今年初め以降、DXY指数は先進国通貨に対する年間下落分の2.5%を反転させた。一方で、このラリーは広範囲に及んでおり、ユーロ、円、スウェーデンクローナが下落の大きな被害を受けている（チャート I-1）。
我々のバイアスは、成長のアウトパフォーマンスが今年後半に米国から世界の他地域へと回転するという点にある。これはドルにとってマイナスであり、景気循環に敏感な通貨に有利に働くだろう。今週は、このシフトから恩恵を受けるはずのユーロとルーニー（カナダドル）を取り上げる。
EUR/USD と製造業サイクル
債券利回りと経済の関係は循環的である。長期債の利回りは経済の成長見通しに関する重要なシグナル機能と見なすことができる。同時に、利回りは特に急速に上昇すると金融環境に直接影響を与える。短期の通貨予測の観点からは、利回りの上昇がどの時点で制約的になるかを見極めることが、相対的な経済成長を予測するうえで非常に有益になり得る。
チャート I-2 は、米国とユーロ圏の相対利回りが1%上昇するたびに、約12か月のラグを経て短期の相対成長が後者（ユーロ圏）に有利に転じることを示している。これは重要であり、EUR/USD と相対成長の相関は短期ではかなり強い（チャート I-3）。したがって、米国とユーロ圏の利回り差の上昇は短期的にはEUR/USD を傷つける可能性があるが、長期的にはユーロ／米国成長にとって有利に働き始めるだろう。
チャート I-2
相対債券利回りと製造業サイクル
相対的な債券利回りと製造業サイクル
相対的な債券利回りと製造業サイクル
チャート I-3
ユーロ圏の経済指標は上振れしている
ユーロ圏の経済指標が上方サプライズとなっている
ユーロ圏の経済指標が上方サプライズとなっている
債券フローとその他の市場シグナル
米国債利回りの上昇にもかかわらず、今年は欧州から米国債の買い増しが増えていない（チャート I-4）。2011年から2020年のドルブル相場では、米利回りの上昇と米国債の購入増加に直接的な相関があった。今回の違いの一つは、カナダ、オーストラリア、ニュージーランド、さらには英国などの他の安全資産債券市場が今日では魅力的な利回りを示している点だ。米利回りはG10他国と比較して全体としてあまり上昇していない。これはユーロが下落できる程度を引き続き抑制するだろう。
他方で、ユーロの上振れ余地はかなり大きい。購買力平価（PPP）の観点から見ると、ユーロは米国に対する割引をリセットするために15%上昇し得る。PPP調整は数年を要する傾向があるが、もし米国が引き続きインフレ誘導的な政策を追求するならば、定義上ユーロのフェアバリューも上昇するだろう（チャート I-5）。
チャート I-4
欧州勢は米国債保有を増やしていない
欧州勢は米国債の保有を増やしていない
欧州勢は米国債の保有を増やしていない
チャート I-5
ユーロは依然やや ##br## 割安である
ユーロは依然としてやや割安である
ユーロは依然としてやや割安である
その他の景気循環的要因もユーロにバネのような反発が起こり得ることを示唆している。銅価格は今年急騰しており、ユーロとの伝統的な関係が乖離している（チャート I-6）。銅は炭素からクリーンな電力への移行から恩恵を受けているが、ユーロも恩恵を受け得る。欧州経済は再生可能技術において長年の経験を有しており、投資資本が投入されればこれらのセクターへの意味のある資金流入が始まる可能性がある。これにより、ブルームバーグの2022年末のEUR/USD 1.23という予想は悲観的すぎると考えられる（チャート I-7）。
チャート I-6
ユーロは近くバネのような反発をする可能性がある
ユーロはまもなくコイルばねのように反発する可能性がある
ユーロはまもなくコイルばねのように反発する可能性がある
チャート I-7
ユーロに対するセンチメントはややリセットされた
ユーロに対するセンチメントがわずかにリセットされた
ユーロに対するセンチメントがわずかにリセットされた
最後に、我々は戦術的ヘッジとしてEUR/JPYをショートしており、ストップは131に厳格に置いている。また、EUR/USD の指値買いを1.15から1.16に引き上げている。
カナダの回復は加速している
チャート I-8
カナダの企業景況感調査の見通しは励みになる内容だった
カナダの企業景況感調査の見通しは好材料だった
カナダの企業景況感調査の見通しは好材料だった
カナダの回復は2月時点の評価よりも早く形になりつつあり、最新のBusiness Outlook Surveyがこれを裏付けている。投資意向と将来の売上成長の双方が非常に強く、前者は数十年ぶりの高水準に達した（チャート I-8）。注目すべき点は以下の通り：
企業の3分の2が売上がパンデミック前の水準を上回ると見ている;
多くの企業は第2波が第1波と比べて売上への影響が小さいか無いと述べている;
一部産業ではまだ供給制約が高いが、全体としてインフレ懸念は比較的抑制されている。
感染第2波が猛威を振るい、国の大部分がロックダウン下にあることを考えると、調査の堅調さは我々にとって驚きであった。とはいえ、投資支出の強さはグローバルな文脈で重要なテーマになりつつあり、カナダは今後数年で対外直接投資（FDI）の大きな流入を受ける可能性がある。
市場はカナダでの利上げペースの速まりを織り込み始めている（チャート I-9）。これは過去10年間では稀な事象であり、グローバル・フィクスト・インカム・ストラテジーの同僚と共に、我々はカナダが利上げサイクルの先導をする可能性は低いと引き続き考えている。しかし、経済の勢いが米国の成長を上回ることを許せば、この見方は変わり得る。
チャート I-9
市場はカナダでの速い利上げを織り込んでいる
市場はカナダの利上げの加速を織り込んでいる
市場はカナダの利上げの加速を織り込んでいる
IMFはカナダの実質GDP成長率を今年5%、来年4.7%と見積もっている。Bloomberg Nanos Confidence Indexによれば成長はこれらを大きく上回る可能性がある（チャート I-10）。
チャート I-10
カナダのGDPは回復基調にある
カナダのGDP、回復基調
カナダのGDP、回復基調
雇用レポートは我々の2月時点の評価以降、著しく改善している（チャート I-11）。BoCモニターのサブコンポーネントを見ると、弱さは経済変数に集中していた。これは変わりつつあり、カナダの失業率は米国の失業率より速く低下している（チャート I-12）。これはCADにとって強気の材料である。
チャート I-11
カナダの雇用回復は堅調
チャート I-12
カナダの雇用は米国に追いつきつつある
カナダの雇用が米国に追いつきつつある
カナダの雇用が米国に追いつきつつある
カナダの住宅市場は加熱している。全体として住宅価格は10%上昇し、多くの都市でそれを大きく上回っている（チャート I-13）。カナダの住宅価格の軌跡は次の通りである：政府の支援とマクロプルーデンシャル措置により低価格都市と高価格都市の価格が収束した。具体的には、バンクーバー（およびある程度トロント）は価格上昇がやや緩やかである一方、他の都市は回復している。しかし、低価格都市で名目所得から逸脱し始めると、より広範なマクロプルーデンシャル措置のリスクが大きく高まる。
第二の点は重要であり、カナダの住宅価格上昇はオーストラリアや米国など他国よりも顕著であった。これは債務増加と購買力低下がカナダ経済にとって重要なマクロリスクとなる可能性が高いことを意味する。住宅建設はカナダ経済において無視できない割合を占めている（チャート I-14）。
チャート I-13
カナダの住宅市場は加熱している
カナダの住宅市場が過熱している
カナダの住宅市場が過熱している
チャート I-14
住宅建設は活況を呈している
住宅建設が活況を呈している
住宅建設が活況を呈している
結論：最近の動きはカナダ銀行が利上げを早める可能性を高めている。これがCADのさらなる上昇を可能にするだろう。
CAD と原油
原油価格はCADにとってもう一つの非常に重要なドライバーである。実際、今年の大半において金利はあまり重要な要因でなく、BoCはカナダの見通しの短期的改善を織り込まない姿勢を示してきた。Covid-19危機とワクチン接種の進展の遅さも回復を損ない、ルーニーの上昇にブレーキをかけた（チャート I-15）。
我々のコモディティ・ストラテジストは、ブレント原油が2023年に75ドルに達すると予測している。これはフォワード市場の価格より高い。フォワード価格の上昇は、CAD高と同義になるだろう。
ただし、カナダは歴史的にブレントやWTIに対して大きな割引で取引されてきたウェスタン・カナディアン・セレクト（WCS）ブレンドを販売している（チャート I-16）。環境基準の強化はカナダに不利に働く。WCSは硫黄含有量が高いためである。パイプライン容量も米国の製油所へカナダ原油を輸送する上で依然として大きなボトルネックである。
チャート I-15
ルーニーは出遅れている
ルーニーは出遅れている
ルーニーは出遅れている
チャート I-16
カナダの原油価格は回復に遅れをとる可能性がある
カナダの原油価格は回復に乗り遅れる可能性がある
カナダの原油価格は回復に乗り遅れる可能性がある
今回の救いとなる点は、米国が大規模なインフラプロジェクトに着手し始めるにつれて、CAD/USD と原油価格の相関が他通貨よりも速く上昇していることだ（チャート I-17）。米国の石油輸入の約50%はカナダから供給されている。Covid-19危機は米国の石油生産をカナダより遅らせ、これが原油価格と通貨の相関上昇を助けた。ポートフォリオの資金流入は今年カナダに加速しており、これが石油株とルーニーに恩恵を与えている。
チャート I-17
USD/CAD の原油感応度は高まっている
USD/CADの原油に対する感度が高まった
USD/CADの原油に対する感度が高まった
投資結論
チャート I-18
CADは割安である
カナダドルは割安だ
カナダドルは割安だ
CADは依然として割安である。実効実質為替レートベースで長期平均より1標準偏差下で取引されている（チャート I-18）。平均回帰に戻れば約10%の上昇余地がある。我々のPPPモデルはより慎重で、ルーニーは約5%割安であることを示唆している。これはなおも84〜85セント圏が射程内にあることを意味する。新たなカナダの回復が本格的な加速に転じれば、CADはさらに上昇する可能性がある。
Chester Ntonifor 外国為替ストラテジスト chestern@bcaresearch.com
通貨
米ドル
チャート II-1
USD テクニカルズ 1
USD テクニカル分析 1
USD テクニカル分析 1
チャート II-2
USD テクニカルズ 2
USDテクニカル 2
USDテクニカル 2
今週の米国の経済指標は堅調であった：
3月のCPIは前年同月比2.6%、前月比0.6%と、いずれも予想を上回った。
3月のPPIは前年同月比4.2%、前月比1%で、予想を上回った。
Empire Manufacturingの調査は4月に17.4から26.3へと大幅に反発した。
小売売上高は特に強く、3月は前月比9.8%であった。
NAHB住宅市場指数は4月に83と引き続き高水準であった。
DXY指数は今週0.5%下落した。堅調なデータを受けての利回りの下落は驚きである。これは債券ショートポジションが混雑したトレードになりつつあるシグナルである可能性が高い。DXY指数は4月にロールオーバーしており、これは季節パターンをサポートする動きである。
レポートリンク：
Arbitrating Between Dollar Bulls And Bears - 2021年3月19日
The Dollar Bull Case Will Soon Fade - 2021年3月5日
Are Rising Bond Yields Bullish For The Dollar? - 2021年2月19日
ユーロ
チャート II-3
EUR テクニカルズ 1
ユーロ・テクニカル 1
ユーロ・テクニカル 1
チャート II-4
EUR テクニカルズ 2
EUR テクニカル 2
EUR テクニカル 2
ユーロ圏の最近のデータはやや良好であった：
2月の小売売上高は前月比3%増加し、予想の1.7%を上回った。
4月のドイツおよびEUのZEW景況感は予想を下回った。
2月の鉱工業生産は前月比1%減少した。
ドイツのCPIは前月比0.5%で、予想と一致した。
ユーロは今週ドルに対して0.5%上昇し、これで2週連続の上昇となった。新たなCovid-19の波は短期的にEUR/USDの重しになる可能性があるが、これによりセンチメントとポジショニング指標がリセットされた。我々の中期指標は大きくロールオーバーしており、これは逆張りの観点からは強気材料である。
レポートリンク：
Portfolio And Model Review - 2021年2月5日
On Japanese Inflation And The Yen - 2021年1月29日
The Dollar Conundrum And Protection - 2020年11月6日
日本円
チャート II-5
JPY テクニカルズ 1
JPY テクニカル 1
JPY テクニカル 1
チャート II-6
JPY テクニカルズ 2
JPY テクニカル分析 2
JPY テクニカル分析 2
日本のデータは混在している：
機械受注は2月に再び減少し、前月比で8.5%低下し、予想の2.8%増を下回った。
しかしより好材料として、工作機械受注は3月に前年同月比65%増加した。
2月のPPIは前月比0.8%で、予想を上回った。
日本円は今週対米ドルで0.4%上昇し、4月におけるG10通貨の中で最も強い通貨の一つである。我々の中期指標は崩壊しており、投機筋はネットで円ショートのポジションを持っている。ポートフォリオヘッジとしてEUR/JPYのショートを継続している。
レポートリンク：
The Dollar Bull Case Will Soon Fade - 2021年3月5日
On Japanese Inflation And The Yen - 2021年1月29日
The Dollar Conundrum And Protection - 2020年11月6日
英ポンド
チャート II-7
GBP テクニカルズ 1
GBP テクニカル分析 1
GBP テクニカル分析 1
チャート II-8
GBP テクニカルズ 2
GBP テクニカル指標 2
GBP テクニカル指標 2
英国の最近のデータはやや良好である：
2月のGDPは前月比0.4%増加し、予想の0.6%増をやや下回った。
2月の鉱工業・製造生産および建設生産はいずれも予想を上回り、それぞれ前月比1%、1.3%、1.6%であった。
2月の対EU貿易赤字は164億となった。
英ポンドは今週対米ドルで0.3%上昇し、G10通貨の中では中位に位置し、ユーロに対しては横ばいであった。英国のワクチン接種の成功と他国の追いつき局面を受け、我々は先週EUR/GBPのショートを利確のために決済した。ポンドに対する投機的なネットポジションが高水準にあることから、中立姿勢を取っている。
レポートリンク：
Portfolio And Model Review - 2021年2月5日
The Dollar Conundrum And Protection - 2020年11月6日
Revisiting Our High-Conviction Trades - 2020年9月11日
豪ドル
チャート II-9
AUD テクニカルズ 1
AUD テクニカルズ 1
AUD テクニカルズ 1
チャート II-10
AUD テクニカルズ 2
AUDのテクニカル分析 2
AUDのテクニカル分析 2
豪州の最近のデータは強かった：
NABのビジネス・コンディションは3月に25となり、2月の17から改善した。
4月のWestpac消費者信頼感指数は前月比6.2%上昇し118.8となり、2010年8月以来の高水準となった。
雇用回復は堅調に推移している。3月には71Kの新規雇用が創出され、予想の35Kを上回った。失業率も5.8%から5.6%に低下した。
豪ドルは今週対米ドルで横ばいであった。しかし、最近の堅調なデータ、貿易条件の急上昇、および高い債券利回りはAUD/USDを回復トレードに適したものにしている。ただし、最近の経済指標が堅調な米国に近いメキシコの存在を考慮し、我々はAUD/MXNをショートしている。
レポートリンク：
The Dollar Bull Case Will Soon Fade - 2021年3月5日
Portfolio And Model Review - 2021年2月5日
Australia: Regime Change For Bond Yields & The Currency? - 2021年1月20日
ニュージーランドドル
チャート II-11
NZD テクニカルズ 1
NZDのテクニカル分析 1
NZDのテクニカル分析 1
チャート II-12
NZD テクニカルズ 2
NZD テクニカル 2
NZD テクニカル 2
今週のニュージーランドのデータは乏しかった：
RBNZは公式キャッシュレートを0.25%に据え置き、資産購入プログラムも維持した。住宅市場は熱を帯びており、成長見通しの不確実性が引用された。
NZIERBのビジネス・コンフィデンスは第1四半期で-13%となり、第4四半期の-6%から低下し、4四半期ぶりの下落となった。
NZDは今週対米ドルで横ばいであった。利上げ発表の日にはNZDが上昇し一方でOISカーブがフラット化したが、これはやや不可解な展開である。我々はOISカーブの反応が適切だと考えている。短期的なNZDの上振れリスクはオーストラリアとの計画されているトラベルバブルである。現在、我々はAUD/NZDをロングしている。
レポートリンク：
Portfolio And Model Review - 2021年2月5日
Currencies And The Value-Versus-Growth Debate - 2020年7月10日
Updating Our Balance Of Payments Monitor - 2019年11月29日
カナダドル
チャート II-13
CAD テクニカルズ 1
CAD テクニカル 1
CAD テクニカル 1
チャート II-14
CAD テクニカルズ 2
CAD テクニカル 2
CAD テクニカル 2
カナダの最近のデータは強かった：
カナダ銀行のBusiness Outlook Surveyは堅調であった。センチメント指標は第1四半期に2.87となり、第4四半期の1.3から上昇し、2018年以降の高水準となった。
3月の雇用レポートは特筆に値する。新規雇用は303Kで予想の100Kを大きく上回った。パートタイムとフルタイムの内訳も健全で、それぞれ175Kと128Kであった。これにより3月の失業率は7.5%に低下し、予想および2月の8.2%を下回った。
カナダドルは今週対米ドルで0.3%上昇した。本文前半でカナダドルについて時間を割いて解説したが、短期的にはやや脆弱かもしれない一方で、今後12か月で84セントに達する可能性がある。
レポートリンク：
Will The Canadian Recovery Lead Or Lag The Global Cycle? - 2021年2月12日
Currencies And The Value-Versus-Growth Debate - 2020年7月10日
More On Competitive Devaluations, The CAD And The SEK - 2020年5月1日
スイスフラン
チャート II-15
CHF テクニカルズ 1
CHF テクニカル分析 1
CHF テクニカル分析 1
チャート II-16
CHF テクニカルズ 2
CHF テクニカル 2
CHF テクニカル 2
今週のスイスのデータは乏しかった：
3月の失業率は3.3%で、予想および前月を下回った。
スイスフランは今週対米ドルで横ばいであり、4月のG10通貨の中で上位のパフォーマーであり続けている。先週のレポートで示したように、フランは今年の最初の3か月での出遅れの反動で反発する局面にあるかもしれない。CHFは米ドルに対して引き続き上昇する可能性があるが、評価面の懸念から我々はEUR/CHFをロングしており、ストップは1.095に厳格に置いている。我々のUSD/CHFの中期指標も反転が見込まれる。
レポートリンク：
Portfolio And Model Review - 2021年2月5日
The Dollar Conundrum And Protection - 2020年11月6日
On The DXY Breakout, Euro, And Swiss Franc - 2020年2月21日
ノルウェークローネ
チャート II-17
NOK テクニカルズ 1
NOKのテクニカル指標 1
NOKのテクニカル指標 1
チャート II-18
NOK テクニカルズ 2
NOK テクニカル指標 2
NOK テクニカル指標 2
ノルウェーの最近のデータは混在している：
2月のGDPは前月比0.5%減少した。
第1四半期の住宅価格は前期比3.4%上昇した。
3月のCPIは前年同月比3.1%で、予想の3.4%増を下回った。
CPIの失望は主に消費財価格の前月比0.6%の下落によるものであった。
ノルウェークローネは今週対米ドルで横ばいであった。Norges Bankが今年利上げを見込まれておりG10で最も早い可能性があるにもかかわらず、今月の弱いインフレデータや世界的な再ロックダウンに伴う原油価格の下落により短期的な下振れリスクがあるかもしれない。戦略的には、我々はドルの最終的な下落に備えてNOKとSEKをロングのまま維持している。
レポートリンク：
Portfolio And Model Review - 2021年2月5日
Revisiting Our High-Conviction Trades - 2020年9月11日
A New Paradigm For Petrocurrencies - 2020年4月10日
スウェーデンクローナ
チャート II-19
SEK テクニカルズ 1
SEK テクニカル 1
SEK テクニカル 1
チャート II-20
SEK テクニカルズ 2
SEK テクニカル指標 2
SEK テクニカル指標 2
スウェーデンの最近のインフレデータは強い：
リクスバンクが重視するCPIFは前年同月比1.9%上昇し、2月の1.5%増を上回った。
エネルギーを除いた数値は1.4%の上昇にとどまったが、ほとんどのインフレ指標は2020年の底から力強く反発している。
スウェーデンクローナは今週対米ドルで1.4%上昇し、今週および4月を通じてG10で最も好調な通貨の一つだった。5年物および10年物のインフレスワップは2%水準を上回って堅調に固定されており、市場はスウェーデンのインフレ上昇を一時的なものとは見なしていない可能性がある。これにより利上げ期待が前倒しされることがある。米国より高い2年実質利回りもSEKを支えるだろう。ただし、新規のCovid-19感染者は依然として懸念材料である。
レポートリンク：
Revisiting Our High-Conviction Trades - 2020年9月11日
Updating Our Balance Of Payments Monitor - 2019年11月29日
Where To Next For The US Dollar? - 2019年6月7日
トレードと予想
フォーキャスト要約
コアポートフォリオ
戦術トレード
指値注文
クローズドトレード
Highlights Duration: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. Employment: The US employment boom is just getting started. Total employment is still 8.4 million below pre-pandemic levels, but 37% of missing jobs are from the Leisure & Hospitality sector where demand is about to surge. Fed: The US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Feature Chart 1Price Pressures Building The past two weeks brought us a couple of interesting developments directly related to the Treasury market. First, long-dated Treasury yields declined somewhat, presumably because many investors concluded that the yield curve is already priced for the full extent of future Fed rate hikes. Second, we received further evidence – from March’s +916k employment report, the 12% year-over-year increase in producer prices and continued elevated readings from PMI Prices Paid indexes – that economic activity is recovering more quickly than even the most optimistic forecasters anticipated (Chart 1). These two opposing forces highlight a tension in the current outlook for US Treasury yields. Yields now look fairly valued on several different valuation metrics, a fact that justifies keeping bond portfolio duration close to benchmark. However, cyclical economic indicators are surging, a fact that suggests yields will keep rising in the near-term, causing them to overshoot fair value for a time. This week’s report looks at this tension between valuation indicators and cyclical economic indicators through the lens of our Checklist To Increase Portfolio Duration. While we think there are convincing arguments in favor of both “At Benchmark” and “Below Benchmark” portfolio duration stances on a 6-12 month investment horizon, we are deciding to stick with our recommended “Below Benchmark” stance for now, until the economic data are more in line with market expectations. Checking In With Our Checklist Back in February, following the big jump in bond yields, we unveiled a Checklist of several criteria that would cause us to increase our recommended portfolio duration stance from “Below Benchmark” to “At Benchmark”.1 As is shown in Table 1, the Checklist contains seven items that can be grouped into two categories: Valuation Indicators that compare the level of Treasury yields to some estimate of fair value Cyclical Indicators that look at whether trends in the economic data are consistent with rising or falling bond yields Table 1Checklist For Increasing Duration Valuation Indicators Chart 2Valuation Indicators As mentioned above, valuation indicators show that Treasury yields are roughly consistent with fair value, suggesting that a neutral duration stance is appropriate. First, consider the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate (Chart 2). Last week, survey estimates from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers were updated to March, and while there was some upward movement in the estimated long-run neutral rate ranges, the median estimates in both surveys were unchanged from January. The result is that the 5-year/5-year forward Treasury yield remains near the top-end of its survey-derived fair value band (Chart 2, top 2 panels). Second, the same two surveys also ask respondents to forecast what the average fed funds rate will be over the next 10 years. We can derive an estimate of the 10-year term premium by subtracting those forecasts from the 10-year spot Treasury yield (Chart 2, bottom 2 panels). In this case, respondents did raise their average fed funds rate forecasts and our term premium estimates were revised down as a result. While both term premium estimates are now below their 2018 peaks, they remain elevated compared to recent historical averages. Third, we turn to the front-end of the yield curve to look at what sort of Fed rate hike path is priced into the market (Chart 3). We see that the market is currently priced for Fed liftoff in December 2022 and for a total of four 25 basis point rate hikes by the end of 2023. Only a handful of FOMC participants forecasted a similar path at the March Fed meeting. Chart 3Market Priced For December 2022 Liftoff We discussed the wide divergence between market expectations and the Fed’s “dot plot” in a recent report.2 Essentially, the divergence boils down to the Fed focusing more on actual economic outcomes while the market takes its cues from economic forecasts. We think there’s good reason for optimism about the economy, and therefore expect that the Fed will revise its interest rate forecasts higher in the coming months as the “hard” economic data improve. However, we should point out that respondents to the New York Fed’s Survey of Primary Dealers and Survey of Market Participants also have much more benign interest rate forecasts than the market, and respondents to those surveys do not share the Fed’s bias toward actual economic outcomes. Table 2 shows that the average respondent to the Survey of Market Participants only sees a 35% chance that the Fed will lift rates before the end of 2022 and the Survey of Primary Dealers displays a similar result. Table 2Odds Of A Fed Rate Hike By End Of Year The wide gap between rate hike expectations embedded in the yield curve and forecasts from both the FOMC and the New York Fed’s surveys suggests that Treasury yields are at least fairly valued, and perhaps too high. However, the most important question is whether the market’s rate hike expectations look lofty compared to our own forecast. As is explained in the below section (titled “The Employment Boom Is Just Getting Started”), we think that the jobs market will be strong enough for the Fed to lift rates before the end of 2022 and that the market’s anticipated rate hike path looks reasonable. However, even this view is only consistent with a neutral stance toward portfolio duration. Chart 4Higher Inflation Is Priced In For our final valuation indicator we focus specifically on the outlook for inflation compared to what is already priced into the forward CPI swap curve (Chart 4). The forward CPI swap curve is priced for headline CPI inflation to rise to 2.7% by May 2022 before falling back down only slightly. In reality, year-over-year headline CPI will probably spike to even higher levels during the next two months but will then recede more quickly. We think it’s reasonable to expect headline CPI inflation to be between 2.4% and 2.5% in 2022, a range consistent with the Fed’s 2% PCE target, but the forward CPI swap curve reveals that this outcome is already priced. All in all, the message from the valuation indicators in our Checklist is that a robust economic recovery is already reflected in market prices. Thus, even with our optimistic economic outlook, Treasury yields look fairly valued, consistent with an “At Benchmark” portfolio duration stance. Cyclical Indicators While valuation indicators perform well over longer time horizons, they are notoriously bad at pinpointing market turning points. It’s for this reason that we augment our Checklist with cyclical economic indicators, specifically high-frequency cyclical economic indicators that correlate tightly with bond yields. First, we look at the ratio between the CRB Raw Industrials commodity price index and gold (Chart 5). The CRB index is a good proxy for global economic growth and gold is inversely correlated with the stance of Federal Reserve policy – gold falls when policy is perceived to be getting more restrictive and rises when policy is perceived to be easing. This ratio has shown little evidence of rolling over and further gains are likely as the economy emerges from the pandemic. We also look at other high-frequency global growth indicators like the relative performance between cyclical and defensive equities and the performance of Emerging Market currencies (Chart 5, panels 2 & 3). The trend of cyclical equity sector outperformance continues while EM currencies have shown some tentative signs of weakness. The US dollar is one particularly important indicator for bond yields. As US yields rise relative to yields in the rest of the world it makes the US bond market a more attractive destination for foreign investors. When US yields are attractive enough, these foreign inflows can stop them from rising. One good indication that US yields are sufficiently high to attract a large amount of foreign interest is when investor sentiment toward the dollar turns bullish. For now, the survey of dollar sentiment we track shows that investors are still bearish on the US dollar (Chart 5, bottom panel). Bearish dollar sentiment supports further increases in bond yields. Chart 5Cyclical Indicators Chart 6Data Surprises Still Positive Finally, we track the US Economic Surprise Index as an excellent summary indicator of the US data flow relative to market expectations. The index also correlates tightly with changes in bond yields (Chart 6). Though the index has fallen significantly from the absurd highs seen late last year, it is still elevated compared to typical historical levels. In general, bond yields tend to rise when the economic data are beating expectations, as indicated by a positive Surprise Index. All in all, we see that the cyclical indicators in our Checklist are sending a very different signal than the valuation indicators. This suggests a high probability that yields could overshoot fair value in the near term. Bottom Line: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. The Employment Boom Is Just Getting Started Chart 7Defining "Maximum Employment" The Fed has conditioned the first rate hike of the cycle on both (i) 12-month PCE inflation being at or above 2% and (ii) the labor market being at “maximum employment”. As we’ve previously written, we see strong odds that the inflation trigger will be met in time for a 2022 rate hike.3 This week, we assess the likelihood that “maximum employment” will be reached in time for the Fed to lift rates next year. Fed communications have made it clear that the FOMC’s definition of “maximum employment” is equivalent to an environment where the unemployment rate is between 3.5% and 4.5% - the range of FOMC participants’ NAIRU estimates – and the labor force participation rate has made a more-or-less complete recovery to pre-pandemic levels (Chart 7). Following March’s blockbuster employment report, we update our calculations of the average monthly nonfarm payroll growth that must occur to hit “maximum employment” by different future dates (Tables 3A-3C). Table 3AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table 3BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table 3CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date For example, to reach the Fed’s definition of “maximum employment” by December 2022, nonfarm payroll growth must average between +410k and +487k per month between now and then. To reach “maximum employment” by the end of this year, payroll growth must average between +701k and +833k over the remaining nine months of 2021. It’s probably unrealistic to expect a return to “maximum employment” by the end of this year, but we do expect at least a couple more monthly payroll reports that are even stronger than last month’s +916k. Our optimism stems from the industry breakdown of the current jobs shortfall. Table 4 shows the change in overall nonfarm payrolls between February 2020 and March 2021. In total, we see that the US economy is missing 8.4 million jobs compared to pre-pandemic. We also see that 3.1 million (or 37%) of those jobs come from the Leisure & Hospitality sector. That sector is predominantly made up of restaurants and bars, two services where demand is about to ramp up significantly as COVID vaccination spreads across the US. A few months in a row of 1 million or more jobs added is highly likely in the near future. Table 4Employment By Industry Bottom Line: We see the boom in employment as just getting started and we expect that the US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance
Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory. Chart 5The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13). Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial ##br##Conditions Chart 15Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency. Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16). This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It ##br##Once Was Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com
The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Chart 6Labor Market Still Well Away From Full Employment BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Chart 11Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing Chart 13Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk. How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities. Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years. How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Global Economy Chart 18US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization. Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials. Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21). Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector. Government Bonds Chart 23Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months. Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance. Commodities Chart 26Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4). Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight. Alternatives Chart 28Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3). Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Chart 31China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation