Developed Countries

Executive Summary Global Oil Price Pushes Up Inflation Expectations The US cut off of Russian energy exports has limited immediate impact because EU trade with Russia continues. Russia is unlikely to embargo the EU as it needs revenues to wage war. However, the EU will diversify away from Russia over time, which means that Russia will intensify its efforts to replace the government in Ukraine. The Biden administration began with an adversarial posture toward the energy sector, both US producers and Gulf Arab petro-states. Now it is adjusting its stance as prices surge. The OPEC states do not favor Biden but have an interest in calibrating production to avoid global recession and prolong their profit windfall. Even if the US restores the 2015 nuclear deal with Iran, which we doubt, investors should fade the oil price implications and stay focused on OPEC. Recommendation (Tactical) Inception Level Inception Date Return Long DXY (Dollar Index) 96.19 Feb 23, 2022 2.9% Bottom Line: Stagflation is the likeliest economic outcome of today’s global supply constraints. Feature Biden’s Oil Policy: Implications Will the Ukraine crisis lead to a US recession? The probability of a recession is 7.7% today, according to the bond market, but the oil price shock suggests that the probability will only increase from here. Stagflation, at least, is now highly likely. Short-term interest rates are rising faster than long-term rates, causing the 2-year/10-year Treasury slope to slide toward inversion, though it is not there yet. That would be a telltale sign of a looming recession (Chart 1). The 3-mo/10-year Treasury yield slope is nowhere near inverting and has a better record of predicting recessions than the 2-year/10-year. The Federal Reserve’s interest rate hikes are expected to cause the 10-year yield to rise and the yield curve to steepen. But exogenous shocks may push short rates even higher. When the oil price doubles, a recession often ensues. Out of the past seven recessions, five of them witnessed an oil spike beforehand. True, not every spike causes a recession. But the causality is clear. Today’s spike is large enough to be recessionary (Chart 2). The critical question is where will the price settle? If it settles above $90-$100 per barrel then it will erode global demand. Chart 1An End-Of-Cycle Crisis? Chart 2Oil Price Often Doubles Before Recessions Most likely the price will settle at around $85 per barrel by the end of 2022, and average $85 in 2023, according to our Commodity & Energy Strategy. High prices will discourage consumption and incentivize new production, leading to a price drop and new equilibrium. The OPEC cartel will increase production because they want to prolong the business cycle. Non-OPEC producers like US shale oil companies will also increase production. It is not likely that the US will significantly lift sanctions on Iran and Venezuela, though that would free up 1.3 million barrels per day and 700,000 barrels per day respectively. More on this below. Even so, this year’s energy spike will feed into a larger bout of inflation that is eroding real incomes. Headline consumer price inflation is running at 7.9% as of February, the highest in four decades. Core inflation is running at 6.4%. The Ukraine war did not prevent the European Central Bank from delivering a hawkish surprise in its fight against inflation on March 10, so it is even less likely to prevent the Fed from delivering a hawkish surprise on March 16. The Fed has a history of hiking rates even during geopolitical crises (as during the Arab oil embargo of 1973), which implies that the war in Ukraine will not prevent the Fed from hiking rates four times or more this year. There is a close relationship between the global oil price and the financial market’s long-term inflation expectations (Chart 3). When the costs of production and transportation go up, investors start to expect higher prices. Expectations are already rising because of the global pandemic, stimulus, supply constraints, wage pressure, and tardy policy normalization. Gasoline prices at the pump will shape consumer expectations (Chart 4). Chart 3Global Oil Price Pushes Up Inflation Expectations Chart 4Geopolitics Compound Inflation Yet high commodity prices are not coinciding with strong global growth and a weak dollar, as one might suspect. Global growth is falling and the dollar is strengthening. The energy shock from Russia will rattle importing countries like Europe, China, and India and thus enhance the dollar’s rise (Chart 5). Investor sentiment will suffer as the war in Ukraine reinforces the secular rise in geopolitical risk. Global policy uncertainty is also rising sharply, which will reinforce the dollar, weighing on global economic activity. Chart 5Dollar Strengthens on Weak Global Growth Bottom Line: A stagflationary dynamic is taking shape. Moreover the risk of recession is underrated by the bond market’s measure of recession probability. Investors should maintain tactically bearish trades and cut losses on cyclically bullish trades that suffer from higher rates and persistent inflation. US Boycotts Russia And Begs OPEC The Biden administration’s decision to ban Russian oil exports – and to encourage private sector boycotts of the Russian energy trade – raises the potential for the Russian conflict to escalate beyond Ukraine’s borders. While a total boycott of Russian oil exports is unlikely, it would be one of the larger oil shocks in modern history (Chart 6). Unlike the Iranian attack on the Saudi oil refinery in 2019, the Russian shock would come amid an existing energy shortage. Chart 6Worst Case Oil Risk in Historical Context There are two critical questions about US policy at this stage: Will the US foist its energy boycott on Europe, triggering a Russian retaliation? This could plunge Europe into recession and further upset the global economy. Will the US convince the OPEC cartel to increase oil production? A production boost would reduce prices and help to rebalance the economy, salvaging the business cycle. The next two sections discuss these options. US Boycotts Russia The first question is how Russia will respond to the US boycott and whether the Biden administration will try to force Europe to adopt the boycott. The US is comfortable boycotting Russian energy because oil and gas imports only account for 0.6% of GDP and those from Russia only 0.04%. Europe cannot make the same decision. While O&G imports are only 2.21% of GDP, and Russian O&G imports at 0.4%, these numbers will spike to near 2008 levels as a result of the price shock (Charts 7A & 7B). Major European countries, notably Germany, have already rejected the US boycott, and any EU direct sanctions require unanimity. The EU is instead outlining a plan to diversify away from Russia more gradually. This is a medium-term threat to Russia and hence a major concern for global stability but it is not an instant cutoff, which would cause an immediate recession in Europe. Chart 7AThe US Is Energy Independent... Chart 7B...The EU Is Not The EU’s plan would theoretically reduce its dependency on Russian energy by 66% by the end of the year. But that is easier said than done. Also, Europe cannot simply swap the US for Russia. American exports to the rest of the world could be redirected to Europe, but the switch requires an overhaul of supply chains. A total switch of US exports to Europe is impracticable in the short run and would leave other US allies dependent on Russian exports (Charts 8A & 8B). Chart 8AUS Will Not Replace Russian Energy Anytime Soon Chart 8BUS Will Not Replace Russian Energy Anytime Soon US shale producers are only starting to increase production. With WTI crude oil at $100, and Henry Hub natural gas spot price at $4.6 per million BTU, American production will speed up. But US companies are more focused on profitability and returns to shareholders than they were at the beginning of the shale boom, which has restrained oil production (Charts 9A & (9B). Chart 9AUS Production And Exports Increase After Pandemic Lull Chart 9BUS Production And Exports Increase After Pandemic Lull   The Biden administration has not yet fully adopted the tactics necessary: promoting the domestic fossil fuel industry and coordinating it for purposes of national strategy. American oil executives complain that while the Biden administration courts foreign energy producers and contemplates arbitrarily lifting sanctions on Iran and Venezuela, it has not approached domestic producers about facilitating production.1 Meanwhile there is a risk that Russia will retaliate against western sanctions by cutting off natural gas to the EU, for instance via the Nord Stream I pipeline. This is a risk, rather than a base case, because Moscow would prefer to sell energy as long as Europe is buying – and even increase the amount it produces at today’s high prices. Russian energy exports to the EU account for 5% of Russian GDP and thus provide an important lifeline at a time when the country is suffering heavily under banking, technology, and trade sanctions (Chart 10). Russian natural resource exports on average provide 43% of government revenue, which is essential for Moscow to carry on its war effort (Chart 11). Chart 10Russia Will Not Punish EU For US Boycott Chart 11Russia Needs EU Energy Imports And yet Russians are now slapping an embargo on agricultural exports, constricting global food supply and pushing up food prices. The implication is that a reduction in energy exports to the EU is not out of the question, especially an incremental reduction aimed at increasing Russian diplomatic pressure on Europe. If the Russians cut off Europe, it will fall into a severe recession and the energy shock will risk a global recession. While US direct trade exposure to Europe is limited, at about 3.8% of GDP (Chart 12A), nevertheless the US would suffer from price pressures. The US is already seeing import prices rise toward 2008 levels (Chart 12B). Chart 12AUS Exposure To The EU Is Limited... Chart 12B...But Its Import Prices Will Rise Bottom Line: The US is boycotting Russian oil but not forcing the EU to join the boycott. Europe is pursuing gradual diversification but Russia is unlikely to cut off Europe’s supply. However, this dynamic is showing signs of faltering, which means investors are justified in taking further risk off the table. US Begs OPEC The Biden administration started off on the wrong foot with the Gulf Arab states by criticizing them for autocratic government and human rights abuses, threatening to withhold arms sales, and trying to restore the 2015 nuclear deal and détente with Iran. Now, with a global energy shock unfolding, Biden is going back to Saudi Arabia and the UAE and imploring them to increase oil production and ease the supply pressure. The Arab states are reportedly giving him the cold shoulder, ignoring his phone calls while answering Russian President Vladimir Putin’s calls.2 These states never have an interest in producing oil at any US president’s beck and call. The US and Iran have also reached a critical stage in nuclear negotiations. So it is only fitting that the Arab states play hard to get. While the UAE ambassador to the US suggested that his country supporting increasing production on March 9, the country’s energy minister said the opposite. However, the core OPEC states are even less likely to do Russia’s bidding. Moscow propped up the Syrian regime, arms and subsidizes Iran, and aspires to gain ever greater control over Middle East exports to Europe. The Gulf states also know that the Russians will produce as much energy as they can since they need the revenues to sustain their war (Chart 13). Chart 13Core OPEC Countries Have An Interest In Increasing Oil Supply The Gulf states rely on the US military for national security, they fear that US-Iran détente will lead to US abandonment and Iranian regional ascendancy, and they seek to sustain their centrality to the global oil market. They want to prolong their export revenues in the context of a growing global economy for the sake of their own delicate internal stability and reforms. They do not aim to incentivize non-OPEC oil production and renewable energy transition with excessive prices, or to trigger a global recession (Chart 14). Hence the Saudi and UAE strategy will be to lower the oil price closer to their fiscal breakeven rate of $82.3 and $62.8 (oil price consistent with a balanced budget) and prolong the business cycle (Chart 15). Chart 14Core OPEC Does Not Want To Threaten Their Fiscal Future Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC The critical factor in the negotiation with the Biden administration will be Iran, their chief rival. Biden is trying to rejoin the 2015 nuclear deal, which would require removing sanctions in exchange for Iran’s halting its nuclear progress. A deal would bring 1.3 million barrels per day online, at least for the next two years or so. It could also prompt the Saudis or others to increase production to prevent Iran from stealing market share, as occurred in 2014 (Chart 16). Any deal would reduce the risk of military conflict in the short term and as such would remove some risk premium from oil prices. If Biden agrees to walk away from the Iran deal, then perhaps the Saudis and UAE will oblige him with a larger and quicker production boost. They know the Democratic Party is doomed in this year’s midterm elections anyway. Sanctions are not preventing the Iranians from exporting oil today and there is very little chance that they will truly abandon their quest for nuclear weapons (Chart 17). Chart 16Production Ramped Up Ahead Of The Iran Deal In 2015 Chart 17Production May Ramp Up Again As Iran Managed To Evade Sanction Either way the core OPEC members need to adjust the oil supply to maintain market share and prolong the business cycle. Taking it all together, investors should expect oil prices to remain volatile and for oil supply risks to remain elevated, meaning that oil prices will likely resume their rise after the expected OPEC intervention. Biden is also tinkering with the idea of easing sanctions on Venezuela. This would take a long time and require regime change to come to fruition. Venezuela produces about 700,000 barrels per day at present, down from about 2 million bpd in 2017.Given the lack of capital, investment, and engineering expertise, the Venezuelans probably cannot increase production beyond 1 million bpd over the next year or so. Of that, maybe 600,000 barrels could be sent to export markets, according to our Commodity & Energy Strategist Bob Ryan. The US cannot remove all sanctions from Venezuela as it does not recognize the legitimacy of President Nicolas Maduro’s regime. The Department of Justice indicted Maduro in 2020. Accommodating Maduro will create even more bad blood between the Democrats and the Cuban-American voters in electorally critical Florida. US companies will be reluctant to get involved in oil production in Venezuela on such a flimsy basis, as they will fear future sanctions if Republicans win in 2024. So investment in Venezuela, and hence oil production, will remain limited even if Biden waives some sanctions. Bottom Line: Biden’s attempts to ease sanctions on Iran and Venezuela are unlikely to have a lasting impact on oil prices. But it is possible that he will convince the OPEC states to increase production, as their own interests support such a move. Investment Takeaways Comparing Russia’s 2022 invasion of Ukraine to the original invasion in 2014, the major trends are parallel: stocks are falling relative to bonds, cyclical sectors are underperforming defensives, and small caps are outperforming large caps (Chart 18A). Chart 18AMarket Response 2022 Versus 2014 Chart 18BMarket Response 2022 Versus 2014 If Russia imposes an energy embargo or OPEC refuses to increase production, then there will be an even larger global energy shock and a European recession that will weigh on global growth. The dollar will stay well bid in the near term. Value stocks are far outpacing growth stocks in the 2022 crisis, in keeping with high inflation and rising bond yields (Chart 18B). While we favor value over growth on a structural basis, we took the opposite stance as a tactical trade at the beginning of this year in expectation of falling bond yields, which has backfired. We are closing this trade for a loss of 7.7%.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Shannon Pettypiece, “White House, oil industry spar anew over drilling as gas prices surge”, NBC News, March 12, nbcnews.com. 2     See Holman Jenkins, “The Putin Endgame,” The Wall Street Journal, March 1, 2022, wsj.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary The Fed is in a tough spot. On the one hand, rising long-dated inflation expectations will incentivize it to tighten more quickly. On the other hand, the flat yield curve and poor risky asset performance point to a heightened risk of recession if it tightens too aggressively. The Fed will try to split the difference by lifting rates at a steady pace of 25 bps per meeting, starting this week. Though upside risks have increased, it remains likely that core inflation will peak within the next couple of months. This will allow the Fed to continue tightening at a steady pace, one that is already well discounted in the market. Monthly Core Inflation By Major Component Bottom Line: Investors should keep portfolio duration close to benchmark and favor yield curve steepeners. Corporate bond spreads will continue to widen in the near-term, but a buying opportunity will soon emerge. A Tough Spot For The Fed A lot has happened since we shifted our portfolio duration recommendation from “below benchmark” to “at benchmark” on February 15. The Russian invasion of Ukraine sent bond yields sharply lower the following week but yields have since recovered and are now close to where they were when we upgraded our duration view (Chart 1). That said, the round-trip in nominal yields masks some significant moves in the real and inflation components. The 10-year TIPS breakeven inflation rate is currently 2.98%, up from 2.45% on February 15, and the 5-year/5-year forward TIPS breakeven inflation rate has moved up to 2.38% from 2.05% (Chart 2). In the past two weeks we’ve also seen a further flattening of the yield curve (Chart 2, panel 3) and widening of credit spreads (Chart 2, bottom panel). Chart 2A Stagflationary Shock Chart 1Round-Trip Taken together, recent market moves are consistent with a stagflationary shock. Long-dated inflation expectations are higher, but the yield curve is flatter and risk assets have sold off. This sort of environment is a complicated one for Fed policy. On the one hand, rising long-dated inflation expectations give the Fed a greater incentive to tighten quickly. On the other hand, rapidly tightening financial conditions increase the risk that the Fed may move too aggressively and push the economy into recession. So what’s the Fed to do? For now, it will try to split the difference. In practice, this means that the Fed will start tightening policy this week and proceed with a steady rate hike pace of 25 basis points per meeting. Once this process starts, we see two possible scenarios. The first possible scenario is that the Fed achieves its “soft landing”. A steady hike pace of 25 bps per meeting proves to be slow enough that financial conditions tighten only gradually, the yield curve retains its positive slope and inflation peaks within the next couple of months, halting the upward trend in long-dated inflation expectations. This benign scenario is still more likely than many people appreciate. For starters, the bond market is already priced for close to seven 25 basis point rate hikes this year, the equivalent of one 25 bps hike per meeting (Chart 3). This means a 50 bps hike at some point this year is required for the Fed to deliver a hawkish surprise to near-term expectations. In our view, a 50 bps hike is unlikely unless long-dated inflation expectations continue to move higher and become obviously “un-anchored”. If inflation peaks within the next couple of months, in line with our base case outlook, then so will long-dated expectations. Chart 3Rate Expectations The second possible scenario is that we see no near-term relief on the inflation front. Global supply chains remain disrupted by the war in Ukraine and surging COVID cases in China, and commodity prices continue their upward march. This would initially lead to even higher long-dated inflation expectations and an even faster pace of expected Fed tightening. It could even lead to a 50 bps Fed rate hike at some point, though we think it’s more likely that it would lead to an inverted yield curve and a severe tightening of financial conditions (i.e. sell off in equities and credit markets) before the Fed even gets the chance to deliver a 50 bps hike. Investment Implications The “soft landing” scenario remains our base case view. The Fed will start tightening in line with current market expectations and core inflation will peak within the next couple of months, keeping long-dated inflation expectations in check. Related Report  US Investment StrategyQ&A On Ukraine, Financial Markets And The Economy The correct investment strategy for this outcome is to keep portfolio duration close to benchmark and to favor a 2/10 yield curve steepener (buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note). Not only is the front-end of the bond market fully priced for a steady hike pace of 25 bps per meeting, but the 5-year/5-year forward Treasury yield is close to median survey estimates of the long-run neutral fed funds rate. This suggests that the upside in long-dated bond yields is limited (Chart 4). As for the yield curve, assuming that the Fed’s well-discounted steady pace of tightening is unlikely to invert the curve, then it makes sense to grab the extremely attractive yield pick-up available in the 2-year note versus a duration-matched cash/10 barbell (Chart 5). Chart 4Close to Fair Value Chart 5A Huge Yield Pick-Up In Steepeners The investment implications of our second “un-anchored inflation expectations scenario” are more difficult to game out. However, we think the most likely outcome is that bond yields would rise initially, driven by inflation expectations, and then plunge once the yield curve inverts and it becomes clear that the Fed will be forced to tighten the economy into recession. This is not our base case scenario, but investors with a 6-12 month investment horizon who wish to position for this outcome should probably extend portfolio duration rather than shorten it. The 2022 Inflation Outlook A key pillar of the “soft landing” scenario described above is that core inflation peaks within the next couple of months and starts to head lower in H2 2022. Today, we’ll assess the likelihood of that occurring by looking at the three main components of core CPI inflation: goods, shelter, and services (excluding shelter). The first fact to consider is that month-over-month core CPI has printed between 0.5% and 0.6% in each of the past five months, almost matching the extreme inflation readings seen between April and June 2021 (Chart 6). If month-over-month core inflation continues to print at 0.5%, then year-over-year core CPI will drop between March and June before rising again to reach 6.3% by the end of the year (Chart 7). Conversely, if month-over-month core inflation declines to 0.3%, then year-over-year core inflation will fall steadily to 4.2% by the end of 2022. Chart 6Monthly Core Inflation By Major Component Chart 7Annual Inflation These two outcomes likely have different implications for policy and markets. The world where core inflation remains sticky above 6% probably coincides with expectations of rapid Fed tightening, a near-term inversion of the yield curve and rising expectations of recession. Conversely, the world where core inflation falls to 4.2% by the end of 2022 and appears to be on a downward trend probably coincides with well-contained inflation expectations and a steady pace of Fed tightening. We therefore want to know which of these outcomes is more likely. To do that we consider the outlooks for core inflation’s three main components. 1. Core Goods Chart 8Goods Inflation Goods have been the main driver of elevated inflation during the past year, especially the new and used car segments (Chart 8). Prior to the pandemic, core goods inflation tended to fluctuate around 0%. Currently, the year-over-year rate is up around 12%. We view a significant decline in core goods inflation as highly likely this year. First off, used car prices – as measured by the Manheim Used Vehicle Index – have already moderated (Chart 8, panel 2), while other measures of supply bottleneck pressures like the ISM manufacturing supplier deliveries and prices paid indexes are rolling over, albeit from high levels (Chart 8, panel 3). Reduced demand should also ease some of the upward pressure on goods prices this year. Consumer spending on goods dramatically overshot its pre-COVID trend during the past two years (Chart 8, bottom panel) as spending on services was often not possible. With US COVID restrictions on the verge of being completely lifted, some spending is likely to shift away from goods and towards services in 2022. The recent news of a surging omicron COVID wave in China and renewed lockdown measures already in place in Shenzhen province may delay the re-normalization of supply chains. As of yet, we think it’s premature for this to alter our view. The omicron experience of other countries suggests that the wave will be quick and that restrictions will not be as severe as in past COVID waves.  2. Shelter Shelter is the largest component of core CPI and it is also the most tightly correlated with the economic cycle. That is, it tends to accelerate when economic growth is trending up and the unemployment rate is falling, and vice-versa. Shelter faces two-way risk in 2022. The upside risk comes from private measures of asking rents and home prices that have already surged. The Zillow Rent Index is up 15% during the past 12 months and the Zillow Home Price Index is up 20% (Chart 9A). Recent research has shown that these private measures tend to feed into core CPI with a lag of about one year.1 The downside risk to shelter inflation this year comes from the economic cycle itself. Chart 9B shows that there is a tight correlation between shelter inflation and the unemployment rate, and between shelter inflation and aggregate weekly payrolls (employment x hours x wages). The unemployment rate’s rapid 2021 decline will not persist this year. The labor market is nearing full employment and last year’s fiscal impulse has faded. Chart 9BShelter Inflation II Chart 9AShelter Inflation I Netting it all out, we think shelter inflation will continue to trend higher for the next few months but will eventually level-off near the end of this year as economic growth slows. 3. Core Services (excluding Shelter) Services inflation printed an extremely strong 0.55% month-over-month in February, though a large portion of that increase was driven by pandemic-related services like airfares and admission to events, increases that will moderate now that the omicron wave has passed. More fundamentally, wage growth is the key driver of services inflation, and it has been extremely strong. The Atlanta Fed’s Wage Growth Tracker is up to 4.3% year-over-year, its highest since 2002, and it is showing signs of broadening out to wage earners of all levels (Chart 10). Though we see wage growth remaining strong, its acceleration is also likely to moderate in the coming months. The Census Bureau’s most recent Household Pulse Survey showed that almost 8 million people were absent from work in February because they were either sick with COVID themselves or caring for someone with COVID symptoms (Chart 11). Near-term wage demands will moderate during the next few months as the pandemic ebbs and these people return to work. Chart 10Wage Growth Is Strong Chart 11Covid Still Weighing On Labor Supply We also must grapple with the possible deflationary fall-out from the recent energy and gasoline price shock. Real household incomes are declining (Chart 12A), and while consumers have ample room to either tap their savings or increase debt to support spending (Chart 12B, top panel), the recent plunge in consumer sentiment suggests that they may behave more cautiously (Chart 12B, bottom panel). Chart 12AReal Incomes Are Falling Chart 12BConsumer Confidence Is Low Putting It Together We could see core goods inflation falling all the way back to a monthly rate of 0% this year. This would be consistent with its pre-pandemic level, but also wouldn’t incorporate any outright price declines – which are also possible. If we additionally assume some further acceleration in Owner’s Equivalent Rent and Rent of Primary Residence, to 0.6% per month, and a slight pullback in services inflation to a still-strong 0.3% per month, then overall core CPI inflation would hit a monthly rate of 0.34%, consistent with annual core CPI inflation of 4.2%. We think this is a reasonable forecast though we see risks to the upside driven by another bout of supply chain pressures in manufactured goods. In general, we expect year-over-year core CPI inflation to reach a range of 4% to 5% by the end of this year. That would be consistent with the “soft landing” scenario described earlier in this report. Corporate Bonds: Waiting For A Buying Opportunity To Emerge Chart 13Corporate Bond Valuation Finally, a quick update on our corporate bond allocation. Corporate bonds have sold off sharply versus Treasuries since February 15. The investment grade corporate bond index has underperformed a duration-equivalent position in Treasury securities by 217 bps while High-Yield has underperformed by a less dramatic 120 bps. With economic risks high and the Fed on the cusp of a tightening cycle, we think further spread widening is likely in the near-term. However, if the “soft landing” scenario described earlier in this report pans out, then we will soon see a buying opportunity in corporate bonds. The 12-month quality-adjusted breakeven spread for the investment grade corporate index has risen close to its historical median, from near all-time expensive levels only a few months ago (Chart 13). While a flat yield curve poses a risk to corporate bond returns, wide spreads may soon become too attractive to ignore. Table 1A shows average historical 12-month investment grade corporate bond excess returns given different starting points for the 3-year/10-year Treasury slope and the 12-month corporate breakeven spread. Table 1B shows 90% confidence intervals for those average returns and Table 1C shows the percentage of instances in which excess returns were above 0%. Table 1AAverage 12-Month Future Investment Grade Corporate ##br##Bond Excess Returns* (BPs) Table 1B90 Percent Confidence Interval Of 12-Month Investment Grade Corporate Bond Excess Returns* (BPs) Table 1CPercentage Of Episodes With Positive 12-Month Investment Grade Corporate Bond Excess Returns* At present, the 3-year/10-year Treasury slope is +9 bps and the 12-month breakeven spread is 18 bps. Historically, this sort of environment is consistent with positive excess corporate bond returns 59% of the time, but with a negative average return overall. That said, if the yield curve retains its positive slope, then a further 18 bps of corporate index spread widening would push the 12-month breakeven spread above the 20 bps threshold. The historical record suggests that this would be an unambiguous buy signal. Bottom Line: We are sticking with our recommended 6-12 month corporate bond allocations for now. We are neutral (3 out of 5) on investment grade and overweight (4 out of 5) on high-yield. A yield curve inversion and heightened risk of recession would cause us to turn more cautious, but we think it’s more likely that widening spreads present us with an opportunity to upgrade our corporate bond allocations within the next few months. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.frbsf.org/economic-research/publications/economic-letter/2022/february/will-rising-rents-push-up-future-inflation/ Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations

Special Report

Executive Summary Is Factor Investing Dead? After decades of outperformance, in the past few years equity factors have started to underperform the broad indexes. But this may just be because US-centric factor research and US-dominated global factor indexes have masked an underlying divergence in the behavior of factor premiums in major countries/regions. In this report, we identify differences in smart beta strategies in the US, euro area (EMU), UK, Japan, Canada, Australia, and emerging markets (EM). Quality and Minimum Volatility factors are the most consistent across all markets. However, the magnitude of the factor premiums varies significantly among certain countries/regions. These variations can be attributed to a factor’s differing exposure to the same sector in specific countries, as well as the diverse performance of the same sector in specific countries. Value/Growth is an inferior framework to sector positioning. Quality remains a better factor than Growth.   Bottom Line: Factor investing is still a viable investing approach, but investors should consider that factor premiums have diverged among major countries/regions. Factor strategies may be less profitable in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country/region. Feature Chart 1Diverging Factor Performance Late last year, quant hedge fund AQR announced it would cut back resources because poor performance had induced significant investor outflows.1 Based on MSCI’s diversified multi-factor (DMF) index, which is a bottom-up 4-factor-index (value, momentum, quality and size) optimized using Barra equity models,2 the global DMF index underperformed the MSCI ACWI by 21% between March 2018 (when the relative performance peaked) and the end of January 2022, even though it had outperformed by 373% over the previous 20 years (Chart 1, top panel). Many clients have asked: Is factor investing dead? As shown in Chart 1, however, MSCI Global DMF’s recent poor relative performance was driven largely by a 23.6% underperformance from the developed markets (DM), especially the US (33% underperformance) and Japan (23.6% underperformance), while the DMF index in the emerging markets (EM) lagged its benchmark by only about 1% in the same period. We have advocated a simple approach to factor allocation to smooth out the cyclicality of individual factors by equally weighting five time-tested factors: Quality, Momentum, Minimum Volatility (Min Vol), Value and Equal Weight. Our equally-weighted-5-factor aggregate (EW5) index is less volatile than the more sophisticatedly optimized DMF; it therefore suffered less underperformance in the same period. However, even with this approach, the regional divergence is still notable, with the EW5 factor index in the developing markets underperforming its benchmark by 9%, while the EM EW5 factor index outperformed its benchmark by about 5.5% (Chart 1, panels 2 and 3). Interestingly, the EW5 index for Japan looks more like that for the US than it looks like the Japanese DMF (Chart 1, panels 4 and 5). This highlights the importance of factor allocation methodology. Table 1US Dominance In Global Markets US equities dominate the global equity index by market capitalization. Momentum and Quality, the two best performing factors globally, have even higher weightings in US companies than the broad benchmark, as shown in Table 1. An academic paper published in 2019 based on studies of the US and 38 international stock markets indicates that the US is the only country with a statistically significant, economically meaningful and robust post-publication decline of long-short equity factor returns.3 This is because the US is the most researched market and large mispriced anomalies are arbitraged away quickly after they are identified in academic publications, which results in lower strategy returns. Most quant funds are US-focused, which may explain the ill fortunes of some quant funds. Smart beta strategies are long-only factor strategies, instead of long-short strategies. At the aggregate level, the MSCI factor indexes in developed markets and emerging markets performed much better than in the US, in line with the academic findings (Chart 1, panels 2, 3, and 4). Yet, the Japanese DMF index’s relative performance peaked in October 2012 and has been in a consistent down trend since that time (Chart 1, panel 5). Our research shows that Japan is not an anomaly. Factor divergence among countries exists not only at the aggregate level, but also at the individual factor level. Factor Performances Diverge Among Countries/Regions Factor returns in the US, UK, EMU, Japan, Canada, Australia, and EM, both in absolute and relative terms, have had notable divergences in the past 20 years, as shown in Table 2.4 Several observations from Table 2: Quality and Min Vol are two factors with positive premiums in all countries. In terms of magnitude, however, Min Vol premiums in the US, Japan and Australia are the closest to zero, while the EM scores the highest. Quality premium in Australia is also close to zero while the UK stands out. Momentum is the best performing factor in all countries/regions except in Japan where it has a slightly negative premium. The ineffectiveness of Momentum in Japan may be due to its cultural biases. Momentum tends to fare better in countries that promote individuality (unlike Japan) and where self-attribution and overconfidence are more pervasive. EM is the only market where our five preferred factors (Momentum, Quality, Min Vol, Value and Equal Weight) have had positive premiums, even though the Value premium is not statistically different from zero, while the Growth premium is negative. Despite the well-telegraphed underperformance of Value versus Growth in the US and global markets, this has not been the case in Japan, Canada, and the EM. Momentum, Quality, Min Vol and Value in the EM and Canada have much higher absolute returns than in the US. This aspect cannot be fully explained by the overall index performance difference between these countries and the US. Even though Momentum, Quality, Min Vol and Value in the UK and euro area have returned much less than their US counterparts, the magnitude of the underperformance of each factor is much smaller than what the overall index performance divergence would imply. Table 2Factor Performance Divergence* The widely quoted explanation for the impressive factor performance in the EM, especially in the Chinese A-share market, is that emerging markets have higher trading costs such that it’s harder to arbitrage away the mispriced anomalies. It’s true that trading cost is higher in the EM than in the US, which explains why there are fewer EM-dedicated quant funds than US-focused quant funds. Trading cost alone, however, cannot fully explain the exceptionally large premiums in EM Momentum, Quality and Min Vol compared with the US. In fact, the market with the best factor relative performance since the end of 2001 has been the UK (Chart 2) where trading costs are comparable to the US. The EM is the second in terms of relative returns even though it is more volatile than the euro area. Canada has also performed better than the US, while Australia has been the least favorable market to harvest any factor premium. Japan behaves more like the US, yet with higher volatility. The risk-adjusted active return, defined as the average of the return difference (between EW5 and benchmark) divided by the volatility of the return difference, on an annualized basis using monthly returns, is illustrated in Chart 3. The chart shows both the full-period (from December 2001 to January 2022) risk-adjusted active return (RAAR) and four-year moving RAAR to demonstrate how factors have evolved in each market. Several observations can be made from Chart 3: In the past 20 years, factor premiums (aka active factor returns) in the US have gone through three stages: High premium, low positive premium and then sharply declining premium to negative territory. The last stage started about four years ago. The US factor premium is at its lowest level in the past 20 years and is also the lowest among the seven countries/regions (Chart 3, panel 5). This supports the argument that too many quant funds trade with each other in the US equity market, resulting in lower and lower factor returns. Japan shares a similar pattern with the US, but on a much smaller scale (Chart 3, panel 4). Canada and Australia are similar because their indexes are dominated by financials and commodities. The four-year RAAR trends oscillate in a similar fashion in both countries, but the Canadian cycle seems to lead the Australian cycle by about 2-1/2 years. Canada has a meaningfully positive average factor premium and its four-year RAAR is near a historical low. In contrast, Australia’s average premium is close to zero and its four-year RAAR is still above previous lows (Chart 3, panels 6 and 7). The EMU is the only market with a positive four-year moving RAAR, currently at the well-established lower bound (Chart 3, panel 2). The UK has the highest average premium. It is the only market in which the four-year RAAR has had large cyclical swings and only two brief periods in negative territory (Chart 3, panel 1). EM is the only market where the four-year RAAR has improved since the Covid-19 pandemic started in March 2020 (Chart 3, panel 3). Chart 2Factor Relative Return Performance* Chart 3Risk-Adjusted Active Performance Bottom Line: US-centric factor research and the US-dominated global factor indexes have masked different behaviors of factors in various countries/regions. Thus, it is important to analyze each market instead of drawing investment conclusions from US-based research. What Drives The Divergence In Quality Premium? The Quality factor has been consistently rewarded, but the magnitude of the Quality premium varies significantly among countries/regions, and non-US countries have low correlations with the US, as shown in Table 2 (on page 4) and Charts 4 and 5. Chart 4Quality Performance Divergence* Chart 5Quality Premium* Country Correlation MSCI Quality is defined by three accounting measures: Return on equity (ROE), debt-to-equity and five-year volatility of EPS YoY growth. Earnings may be affected by accounting standards. Countries have different accounting standards, which may explain part of the country divergence in Quality. Our research focuses on an important aspect of Quality, which is persistence, i.e., a Quality stock today will be a Quality stock in the future. The implication is that the Quality factor index has a low turnover and its sector composition does not change much over time. As such, we can take a snapshot and see the relationship between Quality and sector exposure. The sector weights of the broad benchmark in each market are shown in Table 3. Notably, the US and EM have the highest exposure to the Tech sector while both the UK and Australia have little. Although Australia and Canada are both regarded as commodity-driven markets, they have dissimilar exposures to non-Financials: Australia is concentrated in Materials and Healthcare, while Canada has a more even exposure in Energy, Industrial, Materials and Tech. Table 3Broad Market Sector Compositions Given that Quality is measured on profitability, capital structure and earnings stability, does Quality show universal sector preference? The answer is both Yes and No. Yes, because Quality is universally underweight Financials, Energy and Utilities (Table 4). It is also overweight Tech and underweight Real Estate in all markets, except Australia. Tech has outperformed Financials, Utilities and Energy in general (except for Canada), therefore, these three sector tilts may explain the universal existence of Quality premium (Chart 6). Table 4Quality Index Sector Deviations Chart 6What Drives Quality Premium? However, the commonality ends here. Canadian Tech has underperformed Financials by a very large margin (Chart 6, panel 3), which would have caused a huge underperformance in Quality; Quality indexes in the UK and EMU have benchmark exposures to Tech. So what else have contributed to Quality’s outperformance in these three countries/regions? A look at their exposures to other sectors reveals the answers. In the UK, EMU and Canada, Quality indexes have also overweight tilts in Industrials, Consumer Discretionary and Consumer Staples (Table 4). These three sectors have all outperformed their respective benchmarks in the past 20 years, as shown in Table 5. The table also shows that Consumer Staples is the only sector that has outperformed in all markets, yet both US and Australian Quality indexes underweight this sector. Table 5Sector Performance* In addition, in both the UK and Canada, Quality overweights Materials, which is a top outperforming sector in the UK, but an underperforming sector in Canada. Materials also outperforms in the EMU, yet EMU Quality underweights it. Despite the impressive overall outperformance since 2001, the Quality factor in DM has suffered in the past few years, especially since the Covid 19-induced selloff in March 2020. Quality relative performance in EM peaked long before DM but has stood out as the only significant outperformer since March 2020. This is because profitability in Quality has improved in EM but deteriorated in the US and other DM countries as shown in Charts 7 and 8. Chart 7Quality Premium Driver: ROE* Chart 8Quality Premium Driver: EPS* Chart 9Quality Premium Driver: Valuation* Valuation-wise, Quality indexes in the UK and Canada are at their cheapest levels since 2013, while Japan has become more expensive. Meanwhile, Quality valuation in the US, EMU and Australia is in line with their respective historical average5 (Chart 9). Bottom Line: Quality premium is driven by profitability and has strong sector preferences. The divergence of Quality premium among countries indicates that the same sector in different countries does not necessarily share the same behavior relative to its own benchmark. Sector behaviors in each market have not been as consistent as globalization would have implied, even though “global sectors” have become a well-accepted concept. What Drives The Min Vol Premium Divergence? Beside Quality, Min Vol has consistently outperformed in all the countries/regions in the past 20 years, even though the premiums in the US and Japan are close to zero, as shown in Table 2 on page 4. Over time, however, Min Vol’s relative performance is very cyclical. At the global aggregate level, this cyclicality is determined by its defensive nature given its positive correlation with the relative equity return ratio of Defensives/Cyclicals and negative correlation with bond yields. It is no surprise that the strong recovery in global equities and the rise in bond yields have caused Min Vol to underperform the broad market since March 2020. What is surprising, however, is the magnitude of the underperformance, which cannot be explained by historical relationships (Chart 10). Chart 10What Drives Global Min Vol Premium? Looking at the global aggregate only, however, can provide misguided information, because Global Min Vol is dominated by the US (56.81%) and Japan (9.88%), where Min Vol has performed the worst. In the most recent cycle since March 2020, the US is the only country where Min Vol has deviated sharply from the historical relationship with the relative performance of defensives/cyclicals and with bond yields, incurring the largest relative performance drawdown ever, erasing all the relative gains achieved in the previous two decades (Chart 11A). Japanese Min Vol also suffered large drawdown, but was in line with the defensives/cyclicals, albeit undershooting what implied by the bond yield (Chart 11B). The relative performance of Min Vol in the UK, Canada, EM, and Australia all behaved in line with what is implied by the historical relationships with bond yields and defensives/cyclicals, while Min Vol in EMU does not have a close correlation with defensives/cyclicals (Charts 11 C-G). Chart 11AUS Min Vol Premium Chart 11BJapan Min Vol Premium Chart 11CUK Min Vol Premium Chart 11DEMU Min Vol Premium Chart 11ECanada Min Vol Premium Chart 11FAustralia Min Vol Premium   Chart 11GEM Min Vol Premium Min Vol has become the worst performing factor since March 2020, led by the US, Japan, and EMU, while the UK has been almost flat, as shown in Table 6. This is in stark contrast to its historical track record (Table 2 on page 4) but can be explained by its defensive tilt in a strong equity market. Currently, Min Vol’s general defensive nature is reflected by its overweight in Consumer Staples and underweight in Consumer Discretionary, overweight in Communication Services and underweight in Energy in all markets. In interest-rate-sensitive sectors, Min Vol overweighs Utilities in all markets except Japan and underweights Financials in all markets, except EM (Table 7). Table 6Min Vol Was The Worst Performer Since The Covid-Induced Recovery* Table 7Min Vol Index Sector Deviations Communication Services in the UK and Australia bucked the trend, outperforming the broad market. UK Financial also opposed the trend but did not outperform. In addition, the UK is overweight in Real Estate, which did much better than the broad market (Table 8). Table 8Sector Performance Since March 2020 Chart 12Min Vol Premium Divergence: Valuation* Min Vol in EM has an overweight in Financials, which also outperformed. In addition, EM Consumer Discretionary resisted the general trend, coming in under its benchmark by 17% annualized; an underweight in this sector contributed to EM’s Min Vol’s performance. Why has US Min Vol performed so badly? According to a GAA Special Report published in January 2020, extreme overvaluation of Min Vol relative to the broad market could induce poor subsequent performance in near future. US Min Vol reached peak valuation relative to the market in 2019, and the subsequent underperformance was accompanied by sharp multiple contraction. Currently, Min Vol’s relative valuation is in line with historical average in the US, implying the turnaround since November 2021 may have further staying power (Chart 12). Bottom Line: Global Min Vol’s defensive tilts explain its underperformance since March 2020. However, divergences in the magnitude of underperformance among countries is explained by different sector exposures and the varying performance of some sectors in different countries, in addition to relative valuation. Chart 13Value Vs. Growth: Is This Time Different? Is It Time To Overweight Value Versus Growth? This is one of the most frequently asked questions over the past few years, especially after the turnaround in AQR last year hit the newswire. The impressive performance of AQR so far this year has prompted more heated debate on the sustainability of the “Revenge of Value” after Value's longest streak of underperformance).6 The recent rebound in the relative performance of Value versus Growth has been driven by extremely oversold conditions, very cheap valuation and faster EPS growth led by the rise in global bond yields. Even though sector exposures change over time for Value and Growth, sector exposures to Financials and Tech have been stable since 2010 at the global aggregate level (Chart 13). The large bets in Financial, Utilities and Tech are universal, as shown in Table 9. Other sector exposures in specific countries vary significantly. For example, the US Value/Growth split is basically between Tech, Communication Services and Consumer Discretionary versus the other eight sectors. These three sectors are dominated by a few mega-cap stocks. The other eight sectors are a mixed bag of cyclicals, defensives, and interest rate sensitives, which have different macro drivers. It does not make sense to overweight them together. It is important to note that Consumer Staples and Healthcare are overweight in Growth outside the US and EMU. Table 9Sector Tilts In Value And Growth In addition, Growth has similar sector preferences as Quality (Table 4 and Table 9), which explains the high correlation between the two factor premiums (Chart 14A), However, Quality has been a much better factor than Growth outside the US and Australia. In the US, Quality and Growth are almost the same with a stable correlation, but Quality has been inferior to Growth in Australia (Chart 14B). Chart 14AClose Correlation* Between Quality And Growth Chart 14BQuality Is Superior To Growth Outside US And Australia Finally, Value and Growth behave very differently in various market-cap segments, as shown in Table 10. Despite the well-telegraphed underperformance of Value versus Growth by the media, Value has consistently outperformed Growth in Canada, EM and Japan. Furthermore, mid-cap Value has also outperformed mid-cap Growth universally. Bottom Line: Value is extremely cheap and the rebound from an extremely oversold condition has been supported by the relative earnings trend and a rise in interest rates. Yet the mixed bag of sector exposure makes the Value/Growth allocation inferior to sector allocation. Investors who want to focus on Growth are advised to look for Quality outside of the US and Australia. Conclusions Related Report  Global Asset AllocationValue? Growth? It Really Depends! The US-centric factor research and media coverage have masked an underlying divergence of factor premiums in specific countries/regions. Factor premiums in the UK, EMU, Canada, and EM have been stronger than in the US, while Japan and Australia have been weaker. This divergence can be explained by different sector exposures of the same factor, along with varying behaviors of the same sector in specific countries/regions. While factor investing is not dead, it may be less profitable to utilize in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country. Even though Quality, Min Vol and Momentum have been outperformers in the past 20 years, all factors have embedded cyclicality. We do not advocate factor timing and reiterate our long-standing approach of equally weighting the five factors to smooth out the cyclicality of individual factors. Value/Growth is a popular style split; however, it is an inferior framework to sector positioning. In addition, Quality is a better factor than Growth, which is already included in our five-factor approach.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1      Please see "Quant Hedge Fund Icon AQR Cuts Back as Investors Exit," Chief Investment Officer, dated November 15, 2021. 2     Please see "MSCI Diversified Multiple-Factorindexes Methodology," MSCI.com, dated May 2018. 3     Please see "Anomalies across the globe: Once public, no longer existent?" Journal of Financial Economics, Volume 135, Issue 1, January 2020, Pages 213-230. 4    Historical data for all MSCI factor indexes in major markets is available for this period 5    Since Jan 2013 based on MSCI data availability. 6     Jessica Hamlin, "AQR Posts Record Performance in January," Institutional Investor, dated February 9, 2022.