Economy

Executive Summary Will The War Stall The Expected Downturn In Inflation This Year? The Russia/Ukraine conflict is impacting financial markets across numerous channels – uncertainty, risk aversion, growth expectations & inflation expectations – but all have a common link through soaring commodity prices, most notably for oil. For global bond investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. We recommend investors maintain neutral allocations to inflation-linked bonds versus nominal government bonds across the developed world until there is greater clarity on future global oil production. Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries. Bottom Line: The supply premium on global oil prices will persist until there are signs of more global oil production or less chaos in the Ukraine – neither of which is imminent. Maintain neutral allocations to inflation-linked bonds versus nominal government debt across the developed markets. Feature Chart 1A Broad-Based Surge In Commodity Prices The Russia/Ukraine war has sent an inflationary shock though the world through a very traditional source – rising commodity prices. Energy prices are getting most of the attention, with oil prices back to levels last seen in 2008 and US gasoline prices now above $4 per gallon. The commodity rally is not just in energy, though. Industrial metals prices have also gone up substantially, with the spot prices for copper and aluminum hitting an all-time-high and 16-year-high, respectively (Chart 1). Agricultural commodities have seen even larger increases, with the price of wheat up 22% and the price of corn up 11% since the Russian invasion began on February 24th. Europe is acutely exposed to the war-driven spike in energy prices given its reliance on Russia for natural gas supplies. Natural gas prices in Europe have spiked a staggering 117% since the invasion started, exacerbating a sharp demand/supply imbalance dating back to the reopening of Europe’s economy from COVID lockdowns one year ago (Chart 2). To date, booming energy prices have fueled a huge rise in headline inflation rates in the euro area – producer prices were up 31% on a year-over-year basis in January – but with little trickle down to core inflation which was only up 2.3% in January. High energy prices are not only a problem for global growth and inflation, but also for the future policy moves by central banks. Inflation rates boosted over the past year by commodity supply squeezes and supply chain disruptions were set to decline this year, but the Ukraine shock has thrown that into question. If the benchmark Brent oil price were to hit $150/bbl, this would end the decelerating trend for energy price inflation momentum, on a year-over-year basis, that has been in place since mid-2021 (Chart 3). That means a higher floor for the energy component of inflation indices, and thus overall headline inflation rates, throughout the major economies in the coming months. Chart 2Europe's Reliance On Russian Natural Gas Is A Big Problem​​​​​ Chart 3Will The War Stall The Expected Downturn In Inflation This Year?​​​​​ Chart 4The Oil Price Spike Makes Life More Difficult for CBs How will bond markets respond to higher-than-expected inflation? Rate hike expectations have been highly correlated to the trend of headline inflation in the US, Europe, UK, Canada and Australia over the past year (Chart 4). Currently, overnight index swap (OIS) curves are still discounting between 5-6 rate hikes from the Fed, the Bank of England, the Bank of Canada and the Reserve Bank of Australia before the end of 2022. A single rate hike is still priced into the European OIS curve, even with the Ukraine shock. Global bond yields have been volatile, but surprisingly resilient despite the worries about war and commodity inflation. The 10-year Treasury yield has been trading in a range between 1.7% and 2% since the Russian offensive began, while the 10-year German Bund yield has hovered around 0%. Bond markets are pricing in a stagflation-type outcome of slowing growth and rising inflation, as multiple rate hikes are still discounted despite the geopolitical risks from the war. That reduces the value of using increased duration exposure to position for risk-off moves in a bond portfolio. At the same time, real bond yields are falling and breakeven rates are rising for global inflation-linked bonds – a part of the fixed income universe that looks to offer good protection against the uncertainties of war. Inflation-Linked Bonds – A Good Hedge Against War Risks Since the Russian invasion began, breakeven inflation rates on 10-year inflation-linked bonds have moved higher in the US (+13bps), Canada (+19bps), Australia (+15bps) and even Japan (+15bps). The moves have been even more significant on the European continent – 10-year breakevens have shot up in the UK (+23bps), Germany (+45bps), France (+31bps) and Italy (+36bps). Chart 5Inflation Breakevens Are Rising, Especially In Europe The absolute levels of breakevens in Europe are high in the context of recent history (Chart 5). However, breakevens also look a bit stretched in other countries like the US. Our preferred metric to evaluate the upside potential for inflation-linked bonds is our Comprehensive Breakeven Indicators (CBI). The CBI for each country is comprised of three components: the deviation of 10-year breakevens from our model-implied fair value, the spread between 10-year breakevens and longer-term survey-based inflation expectations (the “inflation risk premium”) and the gap between actual inflation and the central bank inflation target. Those three components are all standardized and added together with equal weights to come up with the CBI. A higher CBI reading suggests less potential for inflation breakevens to widen, and vice versa. Currently, the CBIs for the eight countries in our Model Bond Portfolio universe are close to or above zero, suggesting more limited scope for breakevens to widen further (Chart 6). Only in Canada is the CBI below zero, and only slightly so as high realized Canadian inflation is offset by breakevens trading below both fair value and survey-based measures of inflation (Chart 7). Chart 6Global Inflation Breakeven Valuations Are Not That Cheap In the US, the CBI is above zero mostly because of high realized US inflation. In Europe, the CBIs of the UK, Germany and Italy all are well above zero, while in France the CBI is close to zero. The UK has the highest CBI in our eight-country universe, with all three components contributing roughly equally (Chart 8). The Japanese CBI is also just above the zero line. Chart 7Some Mixed Signals On Inflation Breakeven Valuations​​​​​​ Chart 8European Breakevens Have Adjusted Sharply To The Energy Shock​​​​​​ We have been recommending a relative cautious allocation to global breakeven bonds in recent months. We saw the upside potential on breakevens as capped given the dearth of “cheap” signals on breakevens from our CBIs, especially with central banks moving towards monetary tightening in response to elevated inflation – moves intended to restore inflation-fighting credibility with bond markets. Yet the Ukraine commodity shock has boosted inflation breakevens even in countries with modest underlying (non-commodity) inflation like Japan and the euro area. We now see greater value in owning inflation-linked bonds in global bond portfolios as a hedge against the inflation risks stemming from the Ukraine and the worsening geopolitical tensions between the West and Russia. This is true even without the typical positive signal for breakevens from having CBIs below zero. We recommend that fixed income investors maintain a neutral allocation to inflation-linked bonds in dedicated government bond portfolios across the entire developed market “linker” universe. In our model bond portfolio, we had been allocating to linkers based off the signal from the CBIs, but in the current stagflationary war environment, we see country allocations as secondary to having neutral exposure to linkers in all countries. The new weightings to inflation-linked bonds are shown in the model bond portfolio tables on pages 12-14.1 Bottom Line: For global fixed income investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. Canada Update: BoC Liftoff At Last The Bank of Canada (BoC) raised its policy interest rate by 25bps to 0.5% last week, commencing the start of the first rate hike cycle since 2018. The move was no surprise after BoC Governor Tiff Macklem signaled at the January monetary policy meeting that the start of a rate hiking cycle was imminent. The Canadian Overnight Index Swap (OIS) curve is discounting another 171bps of hikes in 2022, with a peak rate of 1.98% reached by March 2023 - near the low-end of the BoC’s range of neutral rate estimates between 1.75% and 2.75% (Chart 9). Chart 9Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation The BoC noted that the Canadian economy was recovering faster than expected from the effects of the Omicron variant and the associated restrictions on activity, coming off a robust 6.7% annualized real GDP growth rate in Q4/2021. The BoC now estimates that economic slack created by the pandemic shock has been fully absorbed, with the unemployment rate at 6.5%. Canadian headline inflation reached a 32-year high of 5.1% in January (Chart 10) – a level that Governor Macklem bluntly called “too high” in a speech the day following the rate hike. The BoC’s CPI-trim measure that excludes the most volatile components is also at an elevated reading of 4%, suggesting that the higher inflation is broad based. The BoC sees persistent high inflation as a risk to the stability of medium-term inflation expectations, thus justifying tighter monetary policy. According the latest BoC Survey of Consumer Expectations, Canadians expect inflation to be 4.1% over the next two years and 3.5% over the next five years, both of which are above the BoC’s 1-3% inflation target band. So with a robust economy, tight labor market, inflation well above the BoC target and elevated consumer inflation expectations showing no signs of settling, why is the OIS curve discounting such a relatively low peak in the BoC policy rate? The answer lies with Canada’s housing bubble and the associated high household debt levels. In a recent Special Report, our colleagues at The Bank Credit Analyst estimated that the neutral rate in Canada was no higher than 1.75%- the previous peak in rates during the 2017-2018 tightening cycle. A big reason for that was the high level of Canadian household debt, which now sits at 180% of disposable income. This compares to the equivalent measure in the US of 124%, showing that unlike their southern neighbors, Canadian households had little appetite for deleveraging after the 2008 financial crisis (Chart 11). Chart 10Good Reasons For A More Aggressive BoC​​​​​​ Chart 11A Big Reason For A Less Aggressive BoC​​​​​​ Chart 12Position For Narrower Canada-US Bond Spreads The Bank Credit Analyst report estimated that if the BoC hiked rates to 2.5% over the next two years – just below the high end of the BoC neutral range – the Canadian household debt service ratio would climb to a new high of 15.5% (bottom panel). This would greatly restrict Canadian consumer spending and likely trigger a sharp pullback in both housing demand and real estate prices. The conclusion: the neutral interest rate in Canada is likely closer to the peak seen during the previous 2018/19 hiking cycle around 1.75%. We have been recommending an underweight stance on Canadian government bonds in global fixed income portfolios dating back to the spring of 2021. However, with markets now discounting a peak in rates within plausible estimates of neutral, the window for additional underperformance of Canadian government bonds may be closing - but not equally versus all developed economies. We have found that a useful leading indicator of 10-year cross-country government bond yield spreads is the differential between our 24-month discounters. The discounters measure the cumulative amount of short-term interest rate increases over the next two years priced into OIS curves. Currently the “discounter gaps” are signaling room for Canadian spread widening versus the UK and Japan and, to a lesser extent, core Europe (Chart 12). However, the discounter gap is pointing to significant potential for narrowing of the Canada-US 10-year spread over the next year (top panel). This would occur even if the BoC follows the Fed with rate hikes in 2022, as the Fed is likely to deliver more increases in 2023/24 than the BoC. This week, we are introducing two new recommended positions to benefit from narrower Canada-US government bond spreads: We are reducing the size of our underweight position in our model bond portfolio in half, offset by a reduction in the allocation to US Treasuries (see the table on page 13). We are introducing a new trade in our Tactical Overlay, going long Canadian 10-year government bond futures versus selling 10-year US Treasury futures on a duration-matched basis (the specific details of the trade can be found in the table on page 15) We are maintaining our cyclical underweight recommendation on Canada, in a global bond portfolio context, given the potential for Canadian yield spreads to widen versus core Europe, Japan and the UK. That underweight recommendation will be more concentrated versus countries relative to the US. Bottom Line: Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The allocations to inflation-linked bonds shown in the model bond portfolio reflect both the recommended country weights and the recommended weighting of linkers versus nominal bonds within each country.  For example, we are neutral US TIPS versus nominal bonds within the US Treasury component of the portfolio, but since we are also underweight the US as a country allocation, the TIPS allocation is below the custom benchmark index weight. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary A Perfect Metals Storm The bitter truth at the heart of the Ukraine conflict is that the constraints the US and Europe are willing to impose on Russia are not enough to deter it from completing its conquest of the eastern and coastal parts of the country and installing a puppet government in Kiev. The conflict will reduce the available supplies of oil and gas, base metals and grains. Increasing commodity costs will add to existing inflation pressures and threaten to aggravate slowing growth trends in Europe. However, we expect that the net effect in the US will be more inflationary than deflationary, as flush consumers are well positioned to withstand upward price pressure. BCA has turned tactically neutral on equities as it does not appear that stock markets have yet come to terms with the glum reality of the military campaign. We foresee increased near-term market turbulence as investors experience periodic episodes of panic in response to developments on the ground. We are making several moves to dial down the risk in our ETF portfolio for the time being. We plan to unwind the moves before too long to align the portfolio with our bullish 12-month view but are relieved to have adopted a more defensive position while financial markets digest the implications of the geopolitical shock. Bottom Line: Financial market moves seem to be lagging the course of events in Ukraine. We recommend that investors position more defensively until markets catch up. Feature Chart 1Extreme Volatility Ukraine has dominated the news since Russia invaded it a week and a half ago. The fighting has already triggered huge single-day swings in global financial markets with Russian equities falling nearly 40% the day the invasion began and rising 26% the next day before failing to open all of last week (Chart 1, top panel), western European sovereign 10-year bond yields falling by over six standard deviations across the board last Tuesday before retracing much of the move the next day (Chart 1, second panel) and Brent crude moving more than three standard deviations on several days (Chart 1, third panel). The S&P 500’s reversal from losing 3.5% in overnight futures markets to closing up 3% during the New York session on the day of the invasion is modest by comparison, as is the 10-year Treasury yield’s 2-3-standard deviation moves (Chart 1, bottom panel), though they show that the US is not immune. The inevitability that US markets and the US economy will be affected by events seven time zones away has led us to devote this week’s report to Ukraine and its potential consequences. This report is not meant to be the definitive guide to the conflict. It simply synthesizes the views expressed within BCA under the leadership of our Geopolitical Strategy team and adds our own thoughts about market implications and how investors in US markets might prepare to manage their way through the crisis. What’s The Endgame? BCA does not expect Russia to halt its offensive until Kiev is captured and Ukraine’s government is toppled. We therefore view any rallies on hopes for a negotiated settlement to be premature and vulnerable to subsequent reversals. Despite their stirring courage, resolve and pluck, the Ukrainians are massively outgunned and the ultimate military outcome is not in doubt. The cities that are under siege will fall unless Russian forces relent. No one within BCA imagines that Russia will relent until it achieves its aim of establishing a buffer between NATO forces and its own territory. It appears as if the only logical option for Russia’s Vladimir Putin is to proceed until Kiev has fallen. Now that he has already triggered nearly all the economic retaliation that the US and a surprisingly united Europe is likely to muster, there is very little reason not to complete his objective. As dispiriting as it is for humankind, conditions on the ground are likely to get worse. BCA’s base-case scenario is that the military campaign will continue until the coast and all the major cities east of the Dnieper River have succumbed (Map 1). At that point, we expect that the de facto political outcome will leave Russia in control of the eastern half of the country and its southern coast while the remnants of Ukraine’s democratically elected officials establish a new federal government in the country’s west. Once the political borders are redrawn, the active conquest can end. Russia will remain a pariah state, and heated rhetoric between Washington and Moscow and various European capitals and Moscow will wax and wane, but no party will have an incentive to disturb the fragile and uneasy equilibrium. Map 1Tightening The Noose We are saddened by the Ukrainian peoples’ grim plight. We are dismayed by the way that events have laid bare multilateral institutions’ weaknesses. We lament the clinical tone with which we are discussing events that involve extreme human suffering. As we’ve said before, albeit in more comfortable contexts, our job is bullish or bearish, not good or bad and not right or wrong. The coldly objective bottom line is that the US and Europe are unwilling to interpose their own troops or risk escalating tensions with the possessor of the world’s second largest nuclear arsenal over the integrity of Ukraine’s borders. The constraints they are willing to impose on Russia’s actions are insufficient to preserve Kiev and the other cities within its crosshairs. Economic And Market Implications The most immediate economic consequence will be a reduction in the supply of crude oil, natural gas, several base metals and wheat and corn. Russia is the world’s third-largest oil producer; second-largest natural gas producer; a major source of aluminum, copper and nickel; and Russia and Ukraine together account for one-seventh of global wheat and corn production. Banks and shipping companies are increasingly unwilling to finance and transport Russian exports and Ukraine’s ability to cultivate and ship crops will likely be limited by ground-level hazards and Russian control of its ports. Crop and metals prices will rise at least temporarily while alternatives to established trade flows are developed and energy prices could spike if either side cuts off flows between Russia and Europe. Increased energy prices are properly viewed as a tax on economic activity for oil importing economies and the 1973-74 Arab oil embargo’s contribution to the November 1973 to March 1975 recession and the grinding 1973-74 equity bear market loom large in American minds. There are two key distinctions between then and now, however. First, the American economy is far less energy intensive than it was in the early seventies (Chart 2). Second, now that the US is the world’s largest oil producer, rising oil prices lead to increased employment (Chart 3), greater income and marginally better credit performance, given that the energy sector is the plurality issuer of high-yield bonds. Higher oil prices are no longer unadulteratedly negative for the US economy. Chart 3... And Higher Prices Now Mean More Jobs Chart 2Oil Ain't What It Used To Be ... There is a threat, however, that rising commodity prices could push up long-run inflation expectations, forcing the Fed to take a harder line on rate hikes than it otherwise might. Although the 10-year Treasury yield fell last week, inflation expectations rose (Chart 4). Fortunately, American households are unusually well positioned to confront higher inflation, thanks to their modest debt burden, enormous savings cushion and robust pandemic wealth gains powered by advances in financial markets and home prices. We therefore expect that events in Ukraine will prove to be more inflationary than deflationary in the US, though risk-off moves may make it look like the economy is slowing in a worrisome way in the near term. Chart 4Longer-Run Inflation Expectations Have Perked Up From Investment Strategy … Though we are still constructive on financial markets and the economy, we expect that markets will be subject to downdrafts as investors come to terms with the likely course of events in Ukraine. Although our base-case scenario does not include an expansion of the conflict beyond Ukraine’s borders, financial markets will experience additional turbulence as they price in the non-zero probability that it might. Against that backdrop, we are tactically reducing risk in our ETF portfolio and recommend that investors follow suit. … To Portfolio Construction To reduce our near-term exposure to what our Global Investment Strategy colleagues describe as “panic events,” we are temporarily closing out our equity overweight. We are also reducing our cyclicals-over-defensives, value and small-cap positions as a further way of trimming the sails. We are directly investing in two sub-industry groups that will help protect the portfolio against lower interest rates and higher metals prices. To get our overall equity exposure down by 500 basis points (bps), we are reducing our four remaining equal weight sector exposures (Table 1). Table 1Tactical Equity Adjustments In The ETF Portfolio To reduce our cyclicals-over-defensives exposure, we are closing out the respective 160- and 100-bps overweights in Industrials (XLI) and Financials (XLF) while reducing our Consumer Staples (XLP) underweight by 230 bps. Those moves have the effect of reducing our net equity exposure by 30 bps. We are dialing back our Value (RPV) overweight by 250 bps to defend against the potential drag on the Financials-heavy position from lower interest rates and a flatter yield curve. We are trimming our small-cap exposure (IJR) by 100 bps. These moves free up 350 bps of capital. The potential for further war-inspired disruptions leads us to drill down from sectors to sub-industry groups to tailor exposure to homebuilders and miners of metals and alternative fuels. Consumer Discretionaries are rate-sensitive but homebuilders are hyper sensitive, as their customers typically finance 80 to 90% of their purchase price. Every penny of the group’s revenue is earned in the US, which is less exposed to Ukraine disruptions than Europe, Japan (which imports all of its oil and gas) and emerging markets (vulnerable to a rising dollar). Demand is robust (Chart 5), supply will remain limited and the group’s low P/E multiple stands out in a world with few cheap stocks. We are selling 100 bps of our overall sector exposure (XLY) to fund the targeted purchase of ITB, the ETF offering the purest play on homebuilders. We follow the same targeted-exposure playbook in zeroing out our overall Materials position (XLB) to initiate a 150-bps position in XME, a pure-play metals and mining ETF which our Commodity and Energy Strategy team recommends to profit from tight base metals markets (Chart 6). As a tactical move, we are effectively swapping exposure to chemicals, which use natural gas as a feedstock, for base metals, precious metals and coal and uranium. XLB is vulnerable to higher natural gas prices while XME would benefit from them, as well as from base metals supply interruptions and flight-to-safety demand for gold and silver. Given our commodity colleagues’ expectation that alternative energy ambitions will keep base metals well bid for an extended period, XME may remain in the portfolio after markets fully digest Ukraine implications. Chart 5The Homebuilding Outlook ##br##Is Bright Chart 6Metals Inventories Were Tight Before Russian Resources Went Offline The foregoing equity moves reduce our net holdings by 380 bps; we trim each of our four remaining equal weight positions – in Communication Services (XLC), Health Care (XLV), Real Estate (XLRE) and Tech (XLK) – by 30 bps to shed the remaining 120 bps needed to reset equities to equal weight to ride out temporary market turbulence. We also reduce our hybrid preferred stock position (VRP), as there’s less need for variable-rate protection if yields are going to decline and the preferred space may become more volatile as retail investors react to unsettling headlines. The 250-bps hybrid drawdown will be allocated to traditional fixed income, along with 250 bps of the equity sales proceeds, to bulk up our Treasury positions (SHY, IEI and IEF) in the proportion required to maintain benchmark duration (Appendix Table, shown at the back of the report). The remaining 250 bps raised by equity sales will be parked in cash to await an opportunity to re-risk the portfolio in line with our bullish cyclical view. Our relative equity sector positioning as of today is shown in Chart 7 and our relative fixed income positioning is shown in Chart 8. Chart 7Narrowing Our Sector Tilts Chart 8Shrinking Our Treasury Underweight   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Cyclical ETF Portfolio