Economic Growth

Executive Summary Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone ​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral ​​​​​ Chart 8No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels ​​​​​​ Chart 12Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US ​​​​​​ Chart 14Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations ​​​​​​ Chart 15Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 18Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​​ Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase  

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

Listen to a short summary of this report.       Executive Summary Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth It is still possible that equities can outperform bonds over the next 12 months, but the risks to this are rising. Inflation may surprise further to the upside, amid rising commodity prices, pushing the Fed to tighten aggressively.  Tighter financial conditions augur badly for growth (see Chart).  We cut our recommendation for global equities to neutral and increase our allocation to cash. We continue to prefer the lower-beta US stock market over the euro zone and Emerging Markets. We are overweight defensive and structural growth sectors: Healthcare, Consumer Staples, IT and Industrials. Government bond yields have limited upside from here to year-end. We are neutral duration. US high-yield bonds are attractive: They are pricing in a big rise in defaults this year, which we see as unlikely. Recommendation Changes Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious   Bottom Line: Rising uncertainty warrants a more defensive stance. Prudent investors should have only a benchmark weight in equities, and look for other hedges against downside risk. Overview Recommended Allocation Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Rather like Arnold Toynbee’s definition of history, markets in the past few months have been hit by “just one damned thing after another”. But, despite war in Ukraine, big upward surprises to inflation, and a swift aggressive turn by the Fed, global equities are only 6% off their all-time high. It is still possible that equities may outperform bonds over the next 12 months and that the global economy will avoid recession (Chart 1). But the risks to this are rising. We recommend, therefore, that prudent investors reduce their equity holdings to benchmark weight and generally have somewhat defensive portfolio positioning. We put the money raised from going neutral on equities into cash, not bonds. What are the risks? Inflation could surprise further to the upside. Inflation has spread beyond a few pandemic-related items to goods where prices are usually sticky (Chart 2). There are now clear signs that price rises are feeding through to wage increases in the US, UK and Canada – though not yet in the euro area, Japan or Australia (Chart 3). The supply response that we expected to see emerge later this year may be delayed because of Covid lockdowns in China and disruptions in supply from Russia and Ukraine (Chart 4). Consensus forecasts for US core PCE inflation see it coming down to 2.5% by next year. The risk is that it could exceed that. The Fed has got way behind the curve. In retrospect, it should have raised rates last summer – and it now understands its error. Its first hike this cycle came only when the economy had already overheated (Chart 5). The Fed may, therefore, be tempted to get rates up very quickly – something the futures market is now pricing in, since it implies that the year-end Fed Funds Rate will be 2.5%. An aggressive Fed cycle – propelled by inflation fears – is not a good environment for risk assets. Chart 1Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Can Stocks Keep On Outperforming Bonds? Chart 2Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Even Sticky Prices Are Now Rising Chart 3Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Price Rises Feeding Through To Wages In Some Regions Chart 4Supply Chains Remain Disrupted Supply Chains Remain Disrupted Supply Chains Remain Disrupted Financial conditions had already tightened before the Fed hiked because of higher long-term rates, widening credit spreads, and a strengthening dollar. The Goldman Sachs Financial Conditions Index points to the ISM Manufacturing Index falling below 50 later this year (Chart 6). That is the level that historically has been the dividing line between stocks outperforming bonds year-over-year (Chart 7). In particular, the sharp rise in long-term rates (the US 10-year Treasury yield has risen by 110 BPs, and the German yield by 93 BPs over the past seven months) could start to put some pressure on housing markets (Chart 8). Chart 5The Fed Hiked Too Late Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Chart 6Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Tighter Financial Conditions May Affect Growth Chart 7Will PMIs Fall Below 50? Will PMIs Fall Below 50? Will PMIs Fall Below 50? Chart 8Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market Rising Rates Might Dampen The Housing Market The war in Ukraine is unlikely to be a risk in itself. BCA Research’s geopolitical strategists think it very improbable that the conflict will spill beyond the borders of Ukraine – though there remains tail risk of a mistake. But the war is having a big impact on energy prices, especially electricity prices in Europe (Chart 9). The oil price could remain high while Russian oil, which used to be consumed in Europe, is diverted elsewhere. Our Commodity & Energy Strategy service expects that increased supply from OPEC members will bring Brent crude down to around $90 a barrel by year-end. But, as our Client Question on page 14 details, that calculation relies on many assumptions, and the risk is that the oil price stays high. A doubling of the oil price year-on-year (which currently equates to $120/barrel) has historically often been followed by recession (Chart 10). Chart 9Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Europe's Electricity Prices Have Soared Chart 10Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level Oil Price Is Close To The Risk Level China has been easing fiscal and monetary policy. But it is questionable how effective its stimulus will be this time. Confidence in the real estate market remains damaged. And the pick-up in credit growth has been limited to local government bond issuance; there is little sign that the private sector has appetite to borrow (Chart 11). Already some of these risks are affecting economic data. Consumer confidence has collapsed, presumably because of the rising cost of living (Chart 12). Although US activity indicators such as the manufacturing ISM remain elevated (see Chart 6 above), data in Europe is showing notable weakness (Chart 13).   Chart 11China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector China's Stimulus Not Helping The Private Sector Chart 12Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit Consumer Confidence Has Been Hit The yield curve is also getting close to signaling recession. There has been much debate of late about which yield curve to use, with Fed Chair Jerome Powell arguing for the 3-month/3-month 18-month forward curve, rather than the more usual 2/10 year or 3 month/10 year curves (Chart 14). The 2/10 is close to inverting, while the others are still a long way away. All measures of the yield curve have historically given reliable recession signals; the difference is simply a matter of timing, with the 2/10 giving the longest lead time.1 If the Fed ends up tightening as much as it intends, all the yield curves will likely invert within the next year or so. Chart 13European Data Starting To Weaken European Data Starting To Weaken European Data Starting To Weaken Chart 14It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At It Depends On Which Yield Curve You Look At And, despite all these warning signals, forecasts for economic and earnings growth have not been revised down much.  Economists still expect 3.4-3.5% real GDP growth in the US and euro zone this year, well above trend (Chart 15). And, despite the drop in GDP forecasts, earnings forecasts have actually been revised up since the start of the year, with analysts now expecting 9.6% EPS growth in the US and 8.2% in the euro zone (Chart 16). Chart 15GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... GDP Growth Is Still Expected To Be Above Trend... Chart 16...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All ...And Earnings Have Not Been Revised Down At All This all seems too much uncertainty for most asset allocators to want to stay fully risk-on. There are valid arguments that equities and other risk assets can continue to perform (which we outline in the following section, Risks To Our View). But the risks have shifted enough since the start of the year that a more defensive stance is now warranted. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Risks To Our View Chart 17Fed Feedback Loop Back In Action? Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Since our main scenario is somewhat cautious – and sentiment towards risk assets pretty pessimistic – we need to consider what could cause upside surprises to the economy and market. The most likely would be if the Fed were to turn more dovish. But the main trigger for this would be if the stock market fell sharply or growth showed clear signs of slowing – which would obviously be negative for stocks first. This scenario could produce the sort of Fed feedback loop we saw in 2015-17, when tightening financial conditions caused the Fed to ease back on rate hikes (Chart 17). More benign would be a gradual easing of inflation over the summer which would mean that the Fed could eventually hike a little less than the market currently expects. The economy may also not be as vulnerable to higher energy prices and higher rates as we fear. Food and energy are now a much smaller part of the consumption basket than they were in the 1970s (Chart 18). Rates may have a limited impact on the housing market, given the low inventory of new houses, strong household formation, and the fact that, in the US at least, some 90% of mortgages are 30-year fixed rate. Consumers continue to hold large amounts of excess savings – more than $2 trillion in the US alone. This should keep retail sales growth strong, though there might be some shift from spending on goods to spending on services as Covid fears recede (Chart 19). Chart 18Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Consumers Are Less Sensitive To Food And Energy Prices... Chart 19...And So May Keep On Spending ...And So May Keep On Spending ...And So May Keep On Spending Other upside risks include: A ceasefire and settlement in Ukraine (unlikely soon, since Russia will not withdraw without taking over Crimea and the Donbass, something Ukraine could not accept); more aggressive stimulus in China (possible, but only if Chinese growth weakened much further); and a sharp fall in the oil price caused by new supply coming onto the market from Saudi Arabia and North American shale fields, and possibly also Iran and Venezuela. What Our Clients Are Asking What Is The Risk Of Stagflation? Chart 20The Combination Of High Inflation And High Unemployment Was The Key Problem In The 1970s Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Several clients have asked about the risk of stagflation, and how the current episode compares to the 1970s. We can begin by dispelling some myths about the 1970s. There is a notion that this was a decade of poor growth for the US. That is simply not true. Real GDP grew by a solid 3.3% annual rate during the 1970s, higher than in any post-WW2 decade other than the 1990s and the 1960s (Chart 20, panel 1). The underlying problem during the 1970s was the combination of high inflation and a poor labor market. Despite solid growth, the unemployment rate kept grinding higher as inflation was increasing, never dropping below 4.5% even at the peaks of the expansions (Chart 20, panel 2). This situation went against the commonly held belief that it was not possible for both these variables to remain high at the same time for an extended period. With the economy plagued by both high inflation and high unemployment, the Fed faced a difficult dilemma: Keep interest rates too high and the already weak labor market would worsen; keep interest rates too low and inflation would spiral out of control. Throughout the decade, the Fed chose the latter option, causing inflation expectations to become unmoored. Chart 21Demographic Shocks And The Structure Of The Labor Force Led To A Weak Labor Market Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Why was there so much slack in the labor market? Demographics were one of the main culprits. The entrance of baby boomers into the workforce dramatically increased the pool of workers. At the same time, prime-age female participation rose at the fastest pace on record, adding additional supply to the labor force (Chart 21, panel 1). The structure of the labor market also played a key role. Almost a third of employees belonged to a union and most of their salaries were indexed to inflation (Chart 21, panels 2 & 3). This made for a rigid labor market where neither employment nor wages could adjust properly to the economic cycle. True, the oil shocks of 1974 and 1979 exacerbated inflationary pressures. But what made inflation truly pernicious during the 1970s was the inability of the Fed to fight it without compromising its employment mandate. Today the economic picture is very different. Union membership stands at only 10% and cost of living adjustments have essentially disappeared. There is also no labor supply shock on the horizon comparable to the baby boomers or women entering the labor force. This makes the calculus for the Fed easy. With its employment mandate already met, it will simply keep raising rates until inflation is back under control. As a result, the risk that it keeps policy too easy and unleashes further inflationary pressures is relatively low over the next 12 months.     How Will The War In Ukraine Affect The World Economy? Chart 22The Ukrainian War Has Impacted The Global Economy Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Global growth, monetary policy, and employment were projected to return to pre-pandemic trends in 2023. In January, the IMF projected global growth of 4.4% in 2022, but now it is poised to cut its forecast due to the war in Ukraine. According to OECD estimates, global economic growth could be 1% lower than what was previously predicted (Chart 22, panel 1). The conflict is putting fresh strain on overstretched global supply chains, causing the price of many commodities to surge. Russia and Ukraine are relatively small in terms of economic output (together they comprise only 1.9% of global GDP in US dollar terms). But they are very big producers and exporters of energy, metals, and key food items. Russia, for example, produces 12% of global oil, one-third of palladium, and (with Belarus) 40% of potash (used in fertilizers). Ukraine is also a major producer of auto parts, such as wire harnesses. Some European car manufacturers have had to idle factories due to a lack of components.  Global central banks have been increasing interest rates to battle inflation. But higher energy and food prices will require additional rate hikes to ensure price stability. The war in Ukraine could push up world inflation by around 2.5% this year, according to the OECD. Developing economies are in a particularly tight spot, being hit with high inflation in food and basic commodities. Their consumer price indices are very sensitive to these items. Russia and Ukraine are the main global exporters of several agricultural items (for example, they together account for a quarter of global wheat exports) which could cause global food insecurity to increase (Chart 22, panel 2). International sanctions on Russia create a risk for foreign companies with operations there. Withdrawal could have a meaningful effect on earnings. Most multinationals have only limited exposure to Russia, but a small number of prominent names make more than 5% of global revenues from the country (Chart 22, panel 3).   Chart 23AOPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... OPEC Is Able To Cover Supply Shortages... Chart 23B...Unlike Other Countries... ...Unlike Other Countries... ...Unlike Other Countries... Chart 23CTo Restore A Balanced But Tight Market To Restore A Balanced But Tight Market To Restore A Balanced But Tight Market What Is The Risk That The Oil Price Stays High? Our Commodity & Energy strategists see 1.3mm b/d of supply from OPEC coming onto the market beginning in May. Because of this, they expect the price of Brent crude to fall back, to average $93 per barrel this year and next. OPEC core producers fear that low inventories and an oil price above $100 per barrel will lead to demand destruction. They will therefore aim to bring prices down. They have enough spare capacity (approximately 3.2mm b/d) to cover physical deficits in global markets (Chart 23A). However, the risk to this view is tilted to the upside. The key question is whether OPEC producers will in fact ramp up production. The OPEC meeting held on March 2, 2022 noted that current market volaility is a function of geopolitical developments and does not reflect changes in market fundamentals: This could imply a reluctance to increase production as quickly as we expect. Saudi Arabia’s interest in exploiting yuan-settled oil trades with China adds an element of uncertainty. With OPEC’s intention to increase production in question, and Russian oil sanctioned and unlikely to be rerouted easily and quickly, there remains little alternative supply: Countries such as Iraq and Venezuela are unlikely to make up for supply deficits (Chart 23B). The US-Iran talks also add downside uncertainty to our price outlook. Our commodity strategists have recently ended their forecast of a return of 1-1.3mm b/d of Iranian oil (Chart 23C). A no-deal scenario is likely to lead to an escalation in tensions and volatility, warranting higher oil prices in the short term. Nevertheless, there remains the possibility that the US administration will be keen on striking a deal with Iran to reduce the risk of a global oil supply shock. This would, in turn, reduce the risk of military conflict, at least in the short-term, and remove some risk premium from oil prices. It might also lead to further increases in production from the Gulf states to prevent Iran from stealing market share, putting further downward pressure on the oil price.   Chart 24Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? Is It Time To Favor EMU Equities? When Will Euro Area Stocks Rebound?  Chinese policy makers have sounded more aggressive of late in terms of supporting the Chinese economy and stock market, especially property and tech shares. This is a positive development for euro area equities given the region’s strong reliance on the Chinese economy (Chart 24, panel 1).  Euro area equities have been in a structural downtrend relative to US equities, but have historically staged occasional counter-trend rallies (Chart 24, panel 2). It’s possible that stocks in this region may stage another short-term rebound at some point because they are technically oversold, and valuation is extremely cheap (Chart 24, panel 3).  Investors with a longer-term investment horizon, however, should remain underweight euro area stocks until there are more signs that the region is out of its stagflation state. As we argue in the Global Equities section on page 18, the key factor to watch over the next 9-12 months is profitability. Global earnings growth will slow significantly this year in response to higher input costs and lower revenue growth.  As a net importer of energy and industrial metals, euro area earnings growth will continue to slow more than in the US (Chart 24, panel 4). In addition, in times of high uncertainty, we prefer to shelter in less volatile markets. The euro area has a much higher beta than the US (Chart 24, panel 5). Bottom Line: While there could be an opportunity to overweight euro area stocks versus the US tactically, long-term investors should continue to favor the US.   Global Economy Chart 25Global Growth Remains Robust... Global Growth Remains Robust... Global Growth Remains Robust... Overview: Global growth has been strong. But this has triggered a surge in inflation, which is pushing central banks to tighten policy more quickly than was expected even three months ago. At the same time, higher prices – and falling real wages – have started to hurt consumer confidence. This raises the risk of stagflation, particularly if disruptions caused by the war in Ukraine push commodity prices up further. A recession is still unlikely over the next 12-18 months, but the risk of one has clearly risen. US economic growth has remained robust, led by consumption and capex. GDP growth in Q4 was 5.6% QoQ annualized. The ISMs remain strong, with manufacturing at 58.5 and services 58.9 (Chart 25, panel 2). However, there are some early signs of slowdown. The Atlanta Fed Nowcast points to only 0.9% annualized growth in Q1. The effect of higher inflation (with headline CPI at 7.9% YoY) might hurt consumer confidence, since average hourly earnings growth lags behind inflation at only 5.1%. Higher rates could also dampen the housing market. With the average mortgage rate rising to 4.5%, from 3.3% at the end of last year, there are signs of a slowdown in house sales (which fell 9.5% YoY in January). Euro Area: Growth remains decent, with Q4 GDP 4.6% QoQ annualized, and robust PMIs (manufacturing at 57.0 and services at 54.8). However, wage growth lags that in the US (negotiated wages rose only 1.5% YoY in Q4), and the impact of a sharp jump in energy prices (exacerbated by the war in Ukraine) could dent consumption. Recent data have deteriorated noticeably: Consumer confidence collapsed to -18.7 in March, and the March ZEW survey (Chart 26, panel 1) fell to -38.7 (from +48.6 in February). With weak underlying growth, and core CPI inflation a relatively modest 2.7%, the ECB will not need to rush to raise rates. Chart 26...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence ...But Higher Inflation Is Starting To Damage Confidence Japan: Economic growth remains rather anemic. Manufacturing is supported by exports (which rose by 19.1% YoY in January), helping the manufacturing PMI to stay in positive territory at 53.2. But wage growth remains stagnant (0.9% YoY) and the rise in oil prices has pushed up headline inflation to 0.9%, leading to a weakening of consumer sentiment. The services PMI is a weak 48.7. There are hopes that this year’s shunto wage round will lead to strong wage rises (the government is lobbying businesses to raise wages by 3%) but this seems unlikely. With inflation ex food and energy languishing at -1.9% (even if that is distorted by cuts in mobile phone charges), there seems little need for the Bank of Japan to tighten policy. Emerging Markets: Chinese economic indicators remain depressed (Chart 26, panel 3), even though global demand for manufactured goods means exports are rising 16.4% YoY. The authorities have been easing policy, which has led to a mild uptick in credit growth. But there are questions on how effective stimulus will be, since the housing market has been damaged by the problems at Evergrande and other developers, and because China seems to be sticking to its zero-Covid policy. Some other EMs will be helped by the rise in commodity prices: South Africa, for example, saw 4.9% annualized GDP growth in Q4. But many developed countries were forced to raise rates sharply last year because of inflation and this may slow growth in 2022. Brazil’s policy rate, for example, has risen to 11.75% from 2% last April, and that has dampened activity: Brazilian industrial production is falling 7.2% YoY, and retail sales are -1.9% YoY. Interest Rates: Recorded inflation and inflation expectations (Chart 26, panel 4) have risen sharply everywhere. Slowing demand for manufactured goods and a supply-side response should allow monthly inflation to peak over the next few months – although the risks remain to the upside if commodity prices continue to rise. The surge in inflation has pushed up long-term rates, with the US 10-year Treasury yield rising by 82 BPs year-to-date and that in Germany by 73 BPs. However, the market is now pricing in very aggressive tightening by central banks through year-end: 214 BPs of further hikes by the Fed, and even 75 BPs by the ECB. The probability is that neither will do quite that much, and therefore the upside for long-term government bond yields is probably capped around its current level for the next 6-9 months.   Global Equities Chart 27Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Revisions Closely Watch Earnings Closely: Global equities suffered a loss of 4% in Q1/2022 despite strong earnings growth. Except for the Utilities sector, all other sectors have positive 12-month trailing and forward earnings growth. Consequently, overall equity valuation, based on forward PE, is no longer stretched (Chart 27). Going forward, however, the macro backdrop of rising inflation and a slowing economy does not bode well for earnings growth, with the profit margin in developed markets already at a historical high. Rising input costs from both materials and wages will put downward pressure on profit margins while revenue growth slows. BCA Research’s global earnings model suggests that earnings growth will slow significantly this year. As such, we downgrade equities to neutral from overweight at the asset class level (see Overview section on page 2). Within equities, we maintain our already cautious country allocation, which served us well in both 2021 and Q1/22. The out-of-consensus overweight on the US and underweight on the euro area panned out well in Q1 2022, as the US outperformed the euro area by 5.9%. After the more defensive adjustment between the UK and Canada in the March Monthly Update, our country allocation portfolio has been well positioned, with overweights in the US and UK, underweights in the euro area, Canada and emerging markets excluding China, while neutral Australia, Japan, and China. In line with the shift of our structural view on industrial commodities, we upgrade the Materials sector to neutral from underweight at the expense of Real Estate and Communication Services. After these adjustments and the added defensive tilt that we took in the February Monthly Update, our global sector portfolio has a tilt towards defensive and structural growth by being overweight Tech, Industrials, Healthcare and Consumer Staples, underweight Consumer Discretionary, Utilities, and Communication Services, while neutral Materials, Financials, Energy and Real Estate. Chart 28Sector Adjustments Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Sector Allocation: Upgrade Materials To Neutral, Downgrade Real Estate to Neutral, Downgrade Communication Services to Underweight. Russia’s war on Ukraine is a watershed moment for industrial metals. It has altered the dynamics of the metals market which used to be dominated by Chinese demand. We had a structural underweight in the Materials sector because China was undergoing a deleveraging process. Now the Russian-Ukrainian war has demonstrated how dangerous it is for Europe to rely on Russia for energy supply and how important it is for Europe to have a strong military defense system.  Rebuilding Europe’s defense will compete with energy diversification initiatives to boost demand for metals. Such a structural shift no longer warrants an underweight in Materials (Chart 28, panel 1).  In addition, relative valuation in the Materials sector is as low as it was in the early 2000s, right before the multi-year upcycle in Materials’ relative performance (Chart 28, panel 2).  Why not go overweight then? The concern is that the sector is technically overbought due to the sharp rises in metal price. Covid lockdowns in China have disrupted the supply chain in metals, and the Russian-Ukrainian war has further intensified the rise in metals prices due to extremely low inventories. We will watch closely for a better entry point to upgrade this sector to overweight. To finance this upgrade, we downgrade Real Estate to neutral from overweight, and Communication Services to underweight from neutral. Both downgrades are driven by a deteriorating relative earnings growth outlook as shown in Chart 28, panels 4 and 5. Rising mortgage rates do not bode well for the Real Estate sector. “Reopening from Covid lockdowns” reduces the “work from home” tailwind for the Communication Services sector, where relative valuation is also stretched.    Government Bonds Chart 29WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? WILL INFLATION COME DOWN IN 2022? Maintain At-Benchmark Duration. The first quarter of 2022 had seen a steady rise in global bond yields even before the Russian-Ukrainian war, in response to a higher inflation outlook. The negative shock to bond yields from the war was quickly reversed and bond yields continued to march higher as the supply shortage in the commodity complex further pushed up commodity prices and inflation expectations. The US 10-year TIPS breakeven inflation rate has risen above the 2.3-2.5% range that is consistent with the Fed’s 2% PCE target. However, the 5-year/5-year forward breakeven inflation rate, the measure that the Fed pays more attention to, is only slightly above 2.3% (Chart 29, panel 2). The base case of BCA Research’s Fixed Income Strategists is that inflation will moderate in the coming months so that there should be limited upside for bond yields. We already upgraded duration to at-benchmark from below-benchmark, and government bonds to neutral from underweight within the bond asset class in the March Portfolio Update. These are still appropriate going forward with the US 10-year Treasury yield currently standing at 2.33%. Inflation-linked bonds are not cheap anymore. We maintain a neutral stance to hedge against the tail risk of a further rise in inflation.   Corporate Bonds Chart 30Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Continue To Favor High-Yield Credit Since the beginning of the year, investment-grade bonds have underperformed duration-matched Treasurys by 191 basis points, while high-yield bonds have underperformed duration-marched Treasurys by 173 basis points. Even with spreads widening, we continue to underweight investment-grade credits within the fixed-income category. Spreads currently do not offer enough value to warrant a neutral shift. Moreover, investment-grade corporate bonds have been performing poorly compared to high-yield corporate bonds (Chart 30, panel 1). But shouldn’t one expect lower-rated bonds to perform worse in bear markets, and better in bull markets? Our US Bond Service believes that one explanation for the poor performance of investment-grade compared to high-yield bonds is that the industry composition of the two categories is quite different. High-yield has a large concentration in the Energy sector while investment-grade bonds have a larger weighting in Financials. And with the recent surge in oil prices, it’s possible that the strong performance of Energy credits is the reason behind that return divergence. We continue to overweight high-yield bonds, as there is likely to be no material increase in corporate default risk. The market currently implies that defaults will rise to 3.7% during the next 12 months, from 1.2% over the past 12 months (Chart 30, panel 2). That seems too high. What about European credit? The ECB’S hawkish turn and then the Ukranian crisis made yields almost double this year. The spreads for both investment-grade and high-yield corporate bonds have been widening since the beginning of the year (Chart 30, panel 3). Their valuations seem to offer an attractive entry point but investors should be cautious as spreads could continue to widen in response to the negative news from the Ukranian crisis.   Commodities Chart 31Risks To Oil Price Are To The Upside Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Quarterly Portfolio Outlook: Too Much Uncertainty To Ignore – Turn More Cautious Energy (Overweight): Oil prices surged to $120 – the highest level since 2013 – in the aftermath of Russia’s invasion of Ukraine, pricing in sanctions against the nation’s oil producers and an estimated 3-5 mm b/d of supply disruptions (Chart 31, panel 1). While the actual hit to Russian production might end up being lower, Russia accounts for over 10% of global production, almost half of which is exported (Chart 31, panel 2). The price shock was slightly offset by a marginal demand weakness from China amid another outbreak of Covid-19. However, uncertainty regarding how quickly core OPEC producers will ramp up production to fill supply shortages – as well as the breakdown in the US-Iranian talks – continue to keep oil prices jittery. Our Commodity & Energy strategists see 1.3mm b/d of increased supply from OPEC coming onto the market beginning in May. This should bring the price of Brent crude down to average $93 per barrel this year and next. The risks to this view however remain tilted to the upside. For more details, see What Our Clients Are Asking on page 14. Industrial Metals (Neutral): Russia is a major player in the metals market, providing more than a third of the world’s palladium output; it is also the third biggest producer of nickel (Chart 31, panel 3). The prices of those metals, as well as the broad industrial metals complex, have shot up following the invasion: Industrial metals had the largest weekly price change since 1990 in the week following the invasion. The outlook for industrial metals prices is tilted to the upside. Inventories for some of the industrial metals required for the energy transition are low. Moreover, if China implements significant stimulus – and supply remains tight – prices are likely to stay elevated. Precious Metals (Neutral): Gold prices reacted in line with the moves in US real rates over the first quarter of this year, initially relatively flat, before rising in the past few weeks as real rates came down. The upward move in gold prices was further amplified by Russia’s invasion of Ukraine, which pushed the bullion’s price close to $2040, just shy of its all-time high in late 2020. This comes as no surprise: The metal is known (despite its volatility) for its safe-haven and inflation-hedging characteristics. We maintain our neutral exposure to gold. Real rates should start to rise as inflation pressures abate in the second half of the year. Gold is also somewhat expensively valued, with the price in inflation-adjusted terms close to its record high (Chart 31, panel 4).   Currencies Chart 32Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet Don't Turn Bearish On The Dollar Yet US Dollar: The DXY index has risen by 2.3% this quarter. We are maintaining our neutral stance on the US dollar. While the dollar is expensive by more than 20% according to purchasing power parity (PPP), positive momentum continues to be too strong to take an outright bearish position (Chart 32, panels 1 and 2). We will look to downgrade the dollar to underweight when momentum starts to weaken and when there is clear evidence that the Fed will have to back off from its tightening path. Japanese Yen: With stock markets rebounding and expectations of interest-rate hikes rising in the US, the yen has fallen by more than 18% since the beginning of the year. Still, we reiterate the overweight that we placed at the beginning of March. The yen should act as a hedge if global stock markets sell off anew. Moreover, we believe there is now limited upside for US yields, given that there are now more than 250 basis points of Fed hikes priced over the next 12 months. This should put a cap on USDJPY, as this cross is closely tied to the relative expectations of tightening between the US and Japan (Chart 32, panel 3). Canadian Dollar: We are currently underweight the Canadian dollar. Our Commodity and Energy Strategists believe that oil should come down to around $90/barrel by the end of the year. Additionally, the BoC won’t be able to follow along with the Fed in its tightening cycle, given that household debt is much higher in Canada than in the US. Both developments should put downward pressure on the CAD over the next 12 months.   Alternatives Chart 33Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Prepare To Turn To Defensive Alternatives Return Enhancers: We previously suggested that private equity tends to outperform other alternative assets in the early years of expansions as it benefits from cheaper financing opportunities and attractive entry valuations. This view has been correct: Following the large drawdown in Q1 2020 due to Covid, PE returns have significantly outperformed those of hedge funds (Chart 33, panel 1). However, financing conditions are tightening and could weigh down on economic activity and PE returns going forward (Chart 33, panel 2). Preliminary results for Q3 2021 show PE funds returning only around 6% compared to an average quarterly return of 10% since the beginning of the pandemic. Given the time it takes to move allocations in the illiquid space, investors should prepare to pare back exposure from PE, and look for more defensive alternative assets, such as macro hedge funds. Inflation Hedges: We have been of the view that inflation will follow a “two steps up, one step down” trajectory: More likely than not, we are near the top of those two steps. Accordingly, we were positioned to favor real estate over commodities; real estate tends to outperform when inflation is more subdued (close to 2%-3%). Inflation, globally, however has turned out to be stickier than expected and recent economic and political developments have propelled another surge in commodity prices. Scarce inventories, lingering inflation, and a potential significant Chinese stimulus imply, at least in the short-term, that commodity prices have room to run (Chart 33, panel 3). Volatility Dampeners: Timberland and Farmland remain our long-time favorite assets within this bucket. We have previously shown that both assets outperform other traditional and alternative assets during recessions and equity bear markets. Farmland particularly continues to offer an attractive yield of approximately 2.8% (Chart 33, panel 4).   Footnotes 1   Please see BCA Research Special Report, "The Yield Curve As An Indicator," for a detailed analysis of this.   Recommended Asset Allocation Model Portfolio (USD Terms)

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

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

Executive Summary Fed Chair Powell is attempting to steer the US economy between the Scylla of a recession and the Charybdis of entrenched high inflation. In the benign soft-landing outcome, the economy will continue to grow well above trend while inflation abates as spending transitions from goods to services, supply chains are untangled and base effects offer arithmetic relief. Entrenched high inflation would yield the most bearish outcome as it would leave the Fed with no choice but to squash the economy to stuff the inflation genie back into the bottle. We expect that rate hikes will eventually short-circuit the expansion and the equity bull market, but not for at least another year. Disruptions from the Ukraine conflict and China’s COVID surge place the most bullish case out of reach but the bearish end of the continuum is overly defeatist. The biggest threats to our constructive view are worsening Russia-Ukraine shortages, a conflict with Russia beyond Ukraine, new COVID obstacles and a consumer retreat. The Rates Market Thinks The Fed's Overly Ambitious The Rates Market Thinks The Fed's Overly Ambitious The Rates Market Thinks The Fed's Overly Ambitious Bottom Line: We continue to recommend overweighting equities and credit over our cyclical 6-12-month timeframe, but risks are heightened and we will change course if conditions dictate. Feature As telegraphed, the Fed began its rate hiking campaign at last week’s FOMC meeting. It lifted its target range for the fed funds rate 25 basis points (bps) from 0 – 0.25% to 0.25 – 0.5%. In addition to making the nearly unanimously expected 25-bps hike, it indicated that the median FOMC participant expects the funds rate to rise by 25 bps at each of the year’s six remaining meetings and by 87.5 bps in 2023, though Chair Powell stressed the projections are merely a baseline expectation subject to change as economic conditions evolve. Both projections slightly exceeded market expectations going into the meeting. After it ended, the fed funds rate implied by the December 2022 futures contract rose 15 bps to align with the median FOMC voter and the rate implied by the December 2023 fed funds contract rose 18 bps, though it remains about a quarter-point hike shy of the median FOMC projection (Chart 1). Chart 1It Looks Like The Fed Can Only Surprise Hawkishly It Looks Like The Fed Can Only Surprise Hawkishly It Looks Like The Fed Can Only Surprise Hawkishly Chart 2The Dots Turn More Hawkish Between A Rock And A Hard Place Between A Rock And A Hard Place Widening the lens to consider the entire distribution of projected rate hikes (the Fed’s dots), and considering the mean value instead of the median, the dots get slightly more ambitious, revealing that disappointingly high inflation readings would prod the committee to ramp up the pace of its 2022 hikes. Seven of the sixteen FOMC participants expect at least 200 bps of hikes in 2022, with the mean funds rate projection nudging up to 2.05% (Chart 2, top panel). The rates market has the funds rate topping out between 2½ and 2⅝%, about one 25-bps hike below the average participant’s 2.81% and 2.75% year-end 2023 (Chart 2, middle panel) and 2024 (Chart 2, bottom panel) projections. With five FOMC voters expecting a terminal rate of 3% or above, there is scope for an upside surprise if inflation comes in hotter or lasts longer than anticipated. The other changes in the Summary of Economic Projections related to the committee’s GDP and inflation outlook. Participants marked down their median real 2022 GDP growth projection to 2.8% from 4% while increasing their headline and core PCE price index projections about one-and-a-half percentage points to 4.3% and 4.1%, respectively. 2023 and 2024 real GDP growth forecasts were unchanged while inflation expectations were bumped a little higher. The FOMC’s outlook has dimmed slightly, though it is still calling for a soft landing with the economy growing at an above-trend rate and supporting full employment while inflation eases to near its target level. You Can’t Get There From Here Any central bank’s long-run projections will show the economy moving toward its desired target conditions. One probably wouldn’t toil as a central banker if s/he didn’t think the bank’s tools would work and couldn’t say it out loud (even when voting anonymously) if s/he doubted that they might. An investor should therefore never place too much stock in the FOMC’s projections for key economic indicators two and three years out. “[A]ppropriate[ly] firming … monetary policy” is easier said than done, even in the best of times. Related Report  US Investment StrategyThe Last Line Of Inflation Defense (Is Holding Fast) The combination of monetary and fiscal largesse almost certainly staved off a COVID recession, at the cost of fostering some asset-market excesses while quite possibly overstimulating aggregate demand over the intermediate term. The Fed is now left to confront the aftermath with blunt policy tools that work with long and variable lags. It is always a tall order to steer an economy smoothly through the ups and downs of the business cycle; sticking the landing after the pandemic’s emergency monetary and fiscal routines involves a much higher degree of difficulty. Chair Powell put on a brave face in his post-meeting press conference, but he and his colleagues are embarking on this rate hiking cycle under less-than-ideal conditions. “In hindsight, yes, it would have been appropriate to move [to hike rates] earlier. … No one wants to have to put really restrictive monetary policy on in order to get inflation back down. So, frankly, [we] need … [to] … get rates back up to more neutral levels as quickly as we practicably can and then mov[e] beyond [neutral], if [it] turns out to be appropriate.” Bottom Line: Having to move as quickly as is practicable implies that the committee and financial markets might be in for some white-knuckle moments in the months ahead. Soft landings are more common in theory than in practice and it will be especially hard to pull one off now. A Recession Is Not Likely … A narrow margin for error does not mean the Fed is walking a tightrope over two negative extremes, however, and we believe the risks of a growth shortfall are modest. We share Powell’s view that “the probability of a recession within the next year is not particularly elevated.” Aggregate demand is strong and will be supported by households’ and businesses’ fortified balance sheets while the labor market has strength to burn. We think the chair had it just right when he said, “all signs are that this is a strong economy and, indeed, one that will be able to flourish … in the face of less accommodative monetary policy.” Our simple recession indicator, built from components that have reliably provided advance warning, reinforces Powell’s conclusion. The 3-month/10-year segment of the yield curve is not yet close to inverting1 (Chart 3). The year-over-year change in the Conference Board’s Leading Economic Index is way above the zero line that has signaled past recessions (Chart 4). The fed funds rate is nowhere near its equilibrium/neutral level, which we judge to be north of 3%, and it is highly unlikely to get there by the end of the year (Chart 5). Ex-the pandemic, recessions over the last 50-plus years have only occurred when all three components sound the alarm; not one is flashing red now and not one is likely to do so during 2022. Chart 3Recessions Occur When The Yield Curve Inverts, ... Recessions Occur When The Yield Curve Inverts, ... Recessions Occur When The Yield Curve Inverts, ... Chart 4... The Year-Over-Year Change In The LEI Turns Negative ... ... The Year-Over-Year Change In The LEI Turns Negative ... ... The Year-Over-Year Change In The LEI Turns Negative ... Chart 5... And The Target Fed Funds Rate Is Above Its Equilibrium Level ... And The Target Fed Funds Rate Is Above Its Equilibrium Level ... And The Target Fed Funds Rate Is Above Its Equilibrium Level … But Inflation Is A Pressing Concern The Fed is right to take action to try to stem inflation, which has found especially fertile soil. Extraordinary monetary and fiscal stimulus have given demand a persistent tailwind; social distancing funneled spending to goods while rolling global COVID surges slowed production and hampered transport, crimping supply; and domestic COVID infections limited labor force participation, tightening the labor market and exerting upward pressure on wages. Just when COVID was finally relaxing its grip, Russia invaded Ukraine, taking major sources of crude oil, natural gas, wheat, corn and several base metals offline while creating new cargo and shipping bottlenecks. The Omicron variant’s emergence in China could bring new supply disruptions. The upshot is that the Ukraine invasion and COVID’s Asian revival could keep inflation elevated, obscuring mitigating factors like a consumption shift from goods to services (Chart 6), diminishing shipping backlogs (Chart 7), increasing labor force participation and more forgiving year-over-year comparisons (base effects). Upside inflation surprises could open the door to a faster pace of rate hikes than markets have already discounted, especially if stubbornly high inflation begins to push up longer-run inflation expectations. Despite their recent rise, long-run expectations remain well anchored for now (Chart 8), while households’ sizable savings cushion better positions them to withstand higher prices. Chart 6A Transitory Inflation Catalyst A Transitory Inflation Catalyst A Transitory Inflation Catalyst ​​​​​ Chart 7Shipping Bottlenecks Had Been Easing Shipping Bottlenecks Had Been Easing Shipping Bottlenecks Had Been Easing ​​​​​ Chart 8Long-Run Inflation Expectations Are Still Manageable Long-Run Inflation Expectations Are Still Manageable Long-Run Inflation Expectations Are Still Manageable Financial Market Impacts Equities took heart from Powell’s talk of the Fed’s commitment to prevent high inflation from becoming entrenched, but his comments were not uniformly reassuring. He specifically called out the red-hot labor market, a key pillar of the favorable growth outlook, as a source of concern. “[I]f you take a look … at today’s labor market, what you have is 1.7-plus job openings for every unemployed person (Chart 9). So that’s a very, very tight labor market, tight to an unhealthy level, I would say.” The Phillips Curve trade-off between growth and inflation still applies after all, but after a dozen years when policymakers and investors were able to ignore it, equity multiples, credit spreads and Treasury yields may no longer account for it. They seem to still be discounting a have-your-cake-and-eat-it-too environment in which growth, even when it’s above trend, is continuously goosed by accommodative policy. Chart 9Too Tight For The Fed Chair Too Tight For The Fed Chair Too Tight For The Fed Chair There’s also the issue that the Fed’s tools are not suited to fine-tuning economic outcomes. One does not have to be a card-carrying Austrian to harbor some skepticism about central bankers' ability to make targeted tweaks. “[I]n principle, … the idea is we’re trying to better align demand and supply[.] [I]n the labor market, … if you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages. You would have a lot less of a labor shortage. … And basically across the economy, we’d like to slow demand so that it’s better aligned with supply. … Of course, the plan is to restore price stability while also sustaining a strong labor market. That is our intention, and we believe we can do that. But we have to restore price stability.” It’s a happy circumstance when attaining a goal doesn’t involve a sacrifice, but no pain, no gain is adulthood’s default condition. To paraphrase Powell’s press conference guidance, price stability with full employment would be really nice, but if push comes to shove, price stability has to take precedence. The tight monetary policy needed to restore lost price stability would constitute a major headwind for risk assets and the economy. It would spell the end of the equity and credit bull markets while ushering in the next recession. It is our view that the perception that price stability sacrifices are inevitable is still far away enough that risk assets have roughly nine to twelve good months ahead of them, although we hold it with less conviction than we did before Russia attacked Ukraine and Omicron reached China. Both events have the potential to hasten the end of monetary accommodation and drive investors to reconsider their terminal (peak) fed funds rate expectations. We do not expect that investors will revisit their terminal rate expectations until they can glean some empirical evidence of how the economy behaves when the funds rate exceeds 2.25%. If it takes the FOMC at least a year to get to that level, we expect that any major repricing of longer-term Treasury yields is over a year away. The bottom line is that we remain constructive on financial markets and the US economy over our six-to-twelve-month cyclical timeframe, but the clock is ticking and European fighting and Asian COVID infections are threats to our view. We believe that the decline in equity prices and the widening of high-yield credit spreads adequately compensate investors for the increased potential pitfalls, but we remain vigilant and are maintaining our tactically cautious ETF portfolio positioning until some of the clouds lift.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which embeds estimates of the Fed’s future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year.

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Core CPI to Rise Further Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well Energy Inflation: Alive And Well Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Commodity Impulse Is Peaking Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Not Blemish-Free Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? A Coming Chinese Tailwind? A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Bad News Discounted? Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Financials Have Suffered Enough Financials Have Suffered Enough Chart 12Small-Caps Time To Shine Small-Caps Time To Shine Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Is Europe Turning The Corner? Is Europe Turning The Corner? Chart 14Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... Chart 19… And Sweden ... And Sweden ... And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

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

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today ​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. In particular, I will share our view on the announced economic growth target and stimulus measures for this year, as well as our takes on the recent developments in China’s onshore and offshore equity markets. The webcasts will be held on Wednesday, March 23 at 9:00 AM HKT (Mandarin) and Wednesday, March 23 at 9:00 AM EDT (English). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, March 30. Best regards, Jing Sima China Strategist   Executive Summary Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Chinese policymakers set an ambitious goal for this year’s economic expansion. While the growth target is above market consensus and a positive surprise, the path will be full of obstacles. Policy restrictions will be the biggest hurdle. While the authorities will continue to ease some industry policies, it is unlikely that all regulations will be rolled back at once. Therefore, it is questionable whether the announced growth-supporting measures will be enough to offset the housing slump and a slow recovery in consumption. We remain cautious on Chinese stocks. In the near term, equities will face headwinds from risk-off sentiment among global investors and a prolonged downturn in domestic demand. Policymakers will eventually allow more aggressive easing in the next 6 to 12 months. We will look for signs of more reflationary efforts and a better price entry point to upgrade Chinese stocks. We are closing our tactical trade of Long MSCI Hong Kong Index/Short MSCI ACW, due to spillover effects from Chinese offshore tech stock selloff on the Hong Kong equity market. ASSET INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG MSCI HONG KONG INDEX / SHORT MSCI ALL COUNTRY WORLD 1/19/2022 -0.08 Closed Bottom Line: Chinese policymakers are aiming for above-expectation economic growth this year. However, we recommend that investors lie low given the substantial challenges that China faces in expanding its economy. Feature Beijing set the 2022 economic growth target during last week’s National People’s Congress (NPC) at “around 5.5%”, which exceeds the market consensus. The topline growth target is encouraging. However, the announced stimulus measures are less than meets the eye. Fiscal support will increase, but not massively. Monetary policy may ease further. However, the easing efforts since July last year have failed to boost sentiment among private-sector corporates and households. Importantly, policy restrictions in the past several years, such as reducing local governments’ shadow bank borrowing and property developers’ leverage, and stringent counter-COVID measures, are having a lasting effect on the economy. As such, China’s domestic demand will likely remain sluggish until more aggressive policy easing is introduced. Meanwhile, Chinese stock prices in absolute terms have been falling due to global equity market selloffs and concerns about China’s domestic economy, although Chinese onshore stocks have fared better than their offshore peers. We expect that China will eventually allow more substantive easing to shore up growth and meet the target. Meanwhile, investors should remain cautious. We recommend that global shareholders with exposure to Chinese onshore stocks maintain a neutral position in their portfolios for now. We continue to look for signs of more reflationary efforts and the right opportunity to upgrade Chinese onshore stocks, especially if prices decline further in the near term.  We maintain our underweight stance on Chinese offshore stocks, in both absolute terms and relative to global equities. De-listing from the US stock exchange is a real risk for some of the big-name Chinese tech companies. We will provide more insights on this topic in the coming weeks. In the meantime, we are closing our tactical trade: Long MSCI Hong Kong Index/Short MSCI All Country World with a minor 0.08% loss. While the recent steep falls in the MSCI Hong Kong Index prices may provide some buying opportunities in the next 6 to 12 months, near-term downside risks are substantial due to geopolitical tensions as well as a new round of lockdowns in the mainland. An Ambitious Growth Target … The 5.5% growth goal set for 2022 is the lowest in more than three decades, but it is above the consensus forecast of close to 5% and the IMF’s projection of 4.8% (Chart 1). The target also marks a significant departure from the past couple of years and reinforces our view that the authorities are determined to ensure a stable domestic economy amid rising geopolitical turmoil (Table 1). Chart 1China Set An Above-Expectation Growth Target For 2022 China Set An Above-Expectation Growth Target For 2022 China Set An Above-Expectation Growth Target For 2022 Table 12022 Economic And Policy Targets Aiming High, Lying Low Aiming High, Lying Low The stimulus measures unveiled at last week’s NPC imply that Beijing will mainly use fiscal levers to support the economy. Some key takeaways from the published Government Work Report include: Chart 2A Significant Jump In Available SPBs In 2022 Aiming High, Lying Low Aiming High, Lying Low A bigger fiscal push. The fiscal budget is set at 2.8% of GDP this year, or 3.37 trillion yuan, and is a modest decrease from the 3.2% deficit in 2021. The quota for local government special purpose bonds (SPBs) remains unchanged at RMB3.65 trillion yuan. However, local governments will be allowed to carry over SPB proceeds from last year, which will add about RMB1.1 trillion yuan to fund this year’s spending. This translates to about RMB4.7 trillion yuan in SPB in 2022, an 80% jump from the actual usage of 2.57 trillion yuan in 2021 (Chart 2). Furthermore, tax and fee cuts will total RMB2.5 trillion yuan, more than double the 2021 amount. Small and medium enterprises will receive value-added tax credits and refunds. Tax cuts will favor the service sectors most affected by the pandemic, along with manufacturing, and science and technology research. The fiscal budget also includes a record-high transfer from the central to local governments. Adding central government fund transfers and off-budgetary fiscal expenditures, we estimate that the augmented fiscal deficit this year will be around 7.8% of GDP, implying a fiscal thrust of more than 2% of GDP. The estimated thrust will be a reversal from the negative impulse of 2.1% of GDP in 2021 (Chart 3).   Further easing in monetary policy. The government reiterated that money supply and total social financing (TSF) growth should be consistent with nominal GDP growth. We expect another cut next month in the reserve requirement ratio and/or the policy rate. We also maintain our view that the credit impulse – measured by the 12-month change in adjusted TSF as a percentage of GDP – will climb to 29% of GDP (assuming an 8% nominal GDP for 2022), 2 percentage points higher than the 27% of GDP in 2021 (Chart 4). Chart 3Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP ​​Chart 4China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Chart 5"Green Investment" Will Get A Big Boost This Year Aiming High, Lying Low Aiming High, Lying Low A more relaxed carbon reduction policy. The government did not announce an annual numeric target related to de-carbonization or energy consumption intensity reduction. Nonetheless, a more relaxed policy setting will allow flexibility, especially in the first half of the year when infrastructure projects will be accelerated. In the second half, however, there is still a risk that de-carbonization efforts will step up to align the country’s carbon and energy intensity reduction with the 14th Five-Year Plan target. Still, the negative impact from de-carbonization seen last year will be much smaller this year, while green energy development will make an increased contribution to this year’s growth (Chart 5). Bottom Line: China set an ambitious economic growth target of 5.5% for the year, relying on fiscal stimulus to shore up topline economic growth. … But A Challenging Path Ahead Achieving growth of “around 5.5%” will not be easy. As noted in previous reports, the regulations put in place in a wide range of industries since 2017 significantly constrain growth in both credit creation and the economy. Furthermore, aggressive regulatory crackdowns on the property sector and internet-related industries last year, coupled with rising domestic COVID cases and a new round of lockdowns, will likely have enduring ramifications on private-sector sentiment and weaken the effectiveness of policy easing. The following risks are notable: Constraints on infrastructure investment. We expect infrastructure investment to pick up from last year’s meager 0.5% growth. Even so, a larger fiscal impulse for 2022 would not necessarily lead to an outsized increase in infrastructure spending by local governments. In 2019, the fiscal deficit widened to 5% of GDP from 3.5% in 2018 and the quota for local government SPBs increased by 60% from a year earlier. However, infrastructure investment only grew by 3.3% in 2019, 1.5 percentage points higher than that in 2018 (Chart 6). The key factor is that the rebound in shadow banking activities, which highly correlate with infrastructure spending by local governments, was subdued in 2019. The stock of shadow banking continues to shrink in February, indicating that local governments remain extremely cautious in expanding their off-balance sheet leverage (Chart 6, bottom panel). Chart 6Shadow Bank Lending Continues To Shrink In February Shadow Bank Lending Continues To Shrink In February Shadow Bank Lending Continues To Shrink In February Chart 7Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand for housing is still in the doldrums. February’s credit data paints a bleak picture of demand for housing, which is also reflected in recent hard data on home sales (Chart 7). It is questionable whether policymakers will allow a significant re-leverage, i.e. a 2016/17-style widespread easing in the property sector to stimulate demand for housing. So far, the government has stated that the housing policy should be city specific. Some cities have already lowered mortgage rates and down payment thresholds. Pledged supplementary lending, a tool that the government utilized to monetize massively excess inventories in the market in 2015/16, has also ticked up (Chart 8). Nevertheless, we do not expect the authorities to allow a sharp upturn in home prices or leverage by households and/or property developers (Chart 9). The government reiterated its stance at last week’s NPC that “housing is for living in and not for speculation.” Chart 8PSL Injections Ticked Up This Year PSL Injections Ticked Up This Year PSL Injections Ticked Up This Year Chart 9Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Chart 10Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Furthermore, demands for housing and property-sector investment in China are set to structurally shift lower due to the country’s slumping birthrate and shrinking working-age population (Chart 10). China’s total population will start to shrink within the next five years and the United Nations estimates that China’s marriageable population will be less than 350 million by 2030 – a drop of nearly 100 million people from 2010. Slowing urbanization rates are also a constraint for housing demand. China’s urban population growth is on a sharp downtrend; only 12 million people moved to cities last year, less than half the number who migrated in 2016. Weak consumption. The NPC reported that the government will provide support in rural areas for the consumption of new-energy vehicles (NEVs) and home appliances. There also was a mention of services for elder care and tax credits for having babies. However, there was no indication of a fiscal transfer to low-income households or a cash payout/consumption voucher to boost the marginal propensity to spend.   Chart 11Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Ultimately, it will be difficult for Chinese policymakers to bolster consumption without relaxing COVID containment measures (Chart 11). The government has made it clear that relaxing COVID policy will not be possible in the near term, given the ongoing outbreaks in China. Therefore, any improvement in household consumption, which accounts for about 40% of China’s GDP, will remain modest.  Bottom Line: China’s economic progress this year will hinge on whether a rebound in infrastructure investment can offset the negative effects from slumping demand for real estate and weak consumption. Investment Implications China will eventually ease policies more aggressively to ensure a stable domestic economic, financial and political environment against highly uncertain global and domestic backdrops. More easing and stimulus could be forthcoming by mid-2022, especially when the mainland's COVID situation is rapidly worsening and front-loaded fiscal supports will start to lose momentum. Meanwhile, Chinese stocks face substantial downside risks derived from the turmoil in global equity markets and a downturn in domestic profit growth. As witnessed in China’s onshore and offshore risk assets in the past two weeks, a slightly more positive signal from the NPC was not enough to offset the jitters from heightened geopolitical tensions and rising domestic COVID cases (Chart 12A and 12B). Chart 12AChinese Onshore Stocks Are Not Immune To Geopolitical Risks... Chinese Onshore Stocks Are Not Immune To Geopolitical Risks... Chinese Onshore Stocks Are Not Immune To Geopolitical Risks... ​​​​ Chart 12B...But Have Fared Better Than Their Offshore Peers ...But Have Fared Better Than Their Offshore Peers ...But Have Fared Better Than Their Offshore Peers We maintain our neutral stance on Chinese onshore stocks in a global portfolio, but do not yet recommend that investors buy in the onshore market in absolute terms. We also continue to recommend overweight Chinese government bonds versus stocks in the onshore market, and an underweight stance on Chinese offshore equities in both absolute and relative terms.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations