Financial Markets

Executive Summary The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The recent market turmoil means that a 50 bps rate hike is off the table for the March FOMC meeting, but the Fed will proceed with a 25 bps rate hike this month and signal a further steady pace of tightening. As of Monday morning, the market is priced for close to 150 bps of tightening during the next 12 months. This is reasonable assuming that inflation moderates in the second half of the year and that long-dated inflation expectations remain well contained. A moderation of inflation in H2 remains our base case, but the war in Ukraine increases the risk that inflation will be sticky and that long-dated inflation expectations will move higher. The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Bottom Line: An ‘at benchmark’ portfolio duration stance makes sense for now, but the recent drop in Treasury yields could eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Stay tuned.   Feature The Russian invasion of Ukraine is ongoing and financial markets will surely remain volatile until a resolution is reached. For more details on how we see the crisis evolving please refer to last week’s BCA Special Report.1  As we go to press on Monday, the market is trying to digest the impact of sanctions that will block the access of some Russian banks to the SWIFT financial messaging system and freeze some Russian central bank reserves that are held abroad in USD and EUR. Taken together, the sanctions will impart a large stagflationary impulse to the Russian economy and, as would be expected, the Ruble is depreciating rapidly on Monday morning. The reaction in US bond markets is so far more muted. The 10-year Treasury yield is currently 1.86% - down from 1.99% last Wednesday – and the 2-year Treasury yield is 1.44% - down from 1.58% last Wednesday (Chart 1). Movements in the real and inflation components of US Treasury yields do show that the US market is pricing-in some stagflationary contagion. The real 10-year Treasury yield is down to -0.71% (from -0.54% last Wednesday) and the 10-year TIPS breakeven inflation rate is up to 2.57% (from 2.53% last Wednesday). The same divergence between a falling real yield and rising cost of inflation compensation is seen at the 2-year maturity point (Chart 1, bottom 2 panels). The market has also moved to price-in a shallower path for Fed rate hikes compared to last week (Chart 2). The market-implied odds of a 50 bps rate hike this month are now slim and the market is now looking for only 139 bps of cumulative tightening (just under six 25 basis point rate hikes) by the end of this year. Chart 2Fed Funds Rate Expectations Fed Funds Rate Expectations Fed Funds Rate Expectations Chart 1A Stagflationary Shock A Stagflationary Shock A Stagflationary Shock We agree with the market that the heightened uncertainty and tightening of financial conditions takes a 50 bps rate hike off the board for the March FOMC meeting. A 25 bps rate hike this month remains the most likely scenario. However, we also think the market might be over-estimating the extent to which contagion from Russia will limit the pace of Fed tightening later in the year. In fact, we are inclined toward the view that the lasting impact of the crisis on the US economy might be more inflationary than deflationary. Chart 3Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen Expect US/German Yield Differential To Widen The inflationary risk is that a sustained upward shock to the oil price could keep headline inflation higher than it would otherwise be. This could also bleed through into other commodity prices and possibly even to inflation expectations. The textbook central bank response should be to ignore a commodity price shock and set policy based on trends in core inflation. However, in the current environment it will be difficult for the Fed to ignore yet another inflationary shock, especially if long-dated inflation expectations move higher. On the other hand, the economic fallout from a Russian recession will be much worse for Europe than for the United States. European Central Bank (ECB) Chief Economist Philip Lane recently estimated that the Ukrainian war could shave 0.3%-0.4% off Eurozone GDP this year.2 If the shock leads to a wider divergence between Fed and ECB policy expectations, then we would expect to see a widening of US yields versus European yields and upward pressure on the US dollar. Given that US bond yields can only diverge so far from yields in the rest of the world, a stronger dollar may cap any increase in US bond yields and eventually limit the extent of Fed tightening. So far, trends in the dollar and dollar sentiment have been supportive of rising US bond yields, but it will be important to watch this situation in the coming months to see if it changes (Chart 3). Investment Conclusions The heightened uncertainty of the current situation means it makes sense to keep portfolio duration close to benchmark. The Fed is likely to proceed with tightening policy at a steady pace, starting with a 25 bps rate hike this month. Trends in inflation and financial conditions will determine the pace of rate hikes in H2 2022. Right now, our sense is that the lasting impact of the Ukrainian crisis on the US economy will prove to be more inflationary than deflationary. With that in mind, the recent drop in Treasury yields may eventually present us with an opportunity to re-initiate a ‘below-benchmark’ portfolio duration position. Checking In With Our Golden Rule Given the current market turmoil, we think it’s a good time to step back and check in with our Golden Rule of Bond Investing.3  The Golden Rule is a framework that investors can use to implement portfolio duration trades. It states that investors should determine the expected change in the fed funds rate that is priced into markets for the next 12 months and then decide whether the actual change in the funds rate will be greater or less than what is priced in the market. If you expect the fed funds rate to rise by more than what is priced in (a hawkish surprise), you should keep portfolio duration low. If you expect the fed funds rate to rise by less than what is priced in (a dovish surprise), you should keep portfolio duration high. It is admittedly a simple framework, but it does have a strong track record of performance. In general, hawkish surprises coincide with the Bloomberg Barclays Treasury index underperforming cash and dovish surprises coincide with the index outperforming cash (Chart 4). Chart 4The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing More specifically, if we look at rolling 12-month periods going back to 1990, we see that dovish surprises have coincided with positive excess Treasury returns versus cash 85% of the time for an average 12-month excess return of 4.0%. Conversely, hawkish surprises have coincided with negative excess Treasury returns 72% of the time for an average 12-month excess return of -1.5% (Chart 5 & Table 1). Table 112-Month Treasury Excess Returns And Fed Funds Rate Surprises (1990 - Present) Waiting For The Fog To Clear Waiting For The Fog To Clear Chart 5The Golden Rule’s Track Record Waiting For The Fog To Clear Waiting For The Fog To Clear As of today, the market is priced for 149 bps of Fed tightening during the next 12 months. That is very close to six 25 basis point rate hikes at the next eight FOMC meetings. Given our view that inflation will moderate in the second half of the year, this seems like a reasonable forecast that is consistent with our ‘at benchmark’ portfolio duration stance. However, as noted above, we believe the war in Ukraine could lead to an increase in inflationary pressures in the United States. Therefore, we see the balance of risks as tilted toward more rate hikes than are currently discounted rather than fewer. It will be vital to monitor long-dated inflation expectations during the next few months to assess how the pace of Fed rate hikes will evolve. Using The Golden Rule To Forecast Treasury Returns One more application of our Golden Rule framework is that we can use it to create forecasts for Treasury index returns. This is done by first looking at the historical correlation between the Fed Funds Surprise – the difference between the expected 12-month change in the fed funds rate and the realized change – and the change in the Treasury index yield (Chart 6). A regression between these two variables allows us to estimate the change in the Treasury index yield based on an assumed Fed Funds Surprise. Chart 6The Correlation Between Treasury Yields And Fed Funds Surprises Waiting For The Fog To Clear Waiting For The Fog To Clear Once we have an expected 12-month change in the Treasury index yield, we can translate that change into an expected return using the index’s average yield, duration and convexity. The result of this analysis is presented in Table 2. Table 2Using The Golden Rule To Forecast Treasury Returns Waiting For The Fog To Clear Waiting For The Fog To Clear Table 2 shows that we would expect the Treasury index to deliver a total return of 1.82% in a scenario where the Fed lifts rates by 150 bps during the next 12 months. This would equate to the Treasury index beating a position in cash by between 0.07% and 0.83%, depending on whether rate hikes are front-loaded or back-loaded. A pace of one 25 basis point rate hike per meeting (+200 bps during the next 12 months) would lead to the Treasury index underperforming cash by between -2.35% and -3.02%. Conversely, we can see that the index is expected to beat cash by between 3.25% and 3.92% if the Fed only lifts rates four times during the next 12 months. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see BCA Special Report, “Russia Takes Ukraine: What Next?”, dated February 24, 2022. 2 https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/ 3 Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Waiting For The Fog To Clear Waiting For The Fog To Clear Other Recommendations Waiting For The Fog To Clear Waiting For The Fog To Clear

Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected.   Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist   False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade A New Cold War A New Cold War For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years A New Cold War A New Cold War Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles.    Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5).  Chart 4Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… A New Cold War A New Cold War   Chart 8...Especially Against The Euro A New Cold War A New Cold War The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix A New Cold War A New Cold War Special Trade Recommendations A New Cold War A New Cold War Current MacroQuant Model Scores A New Cold War A New Cold War

Executive Summary Through February 24th, our ETF portfolio outperformed its benchmark by 18 basis points. Its risk-friendly orientation helped it generate double that amount of outperformance in its first two weeks but cost it as markets broadly declined over the last two weeks. In line with our fixed income strategists’ recommendation, we are tactically shifting our fixed income positioning to neutral duration from below-benchmark duration. Our longer-run expectation for higher interest rates remains intact. We are not making any portfolio adjustments in response to Russia’s invasion of Ukraine. Although the situation is fluid, we share the BCA house view that the conflict will be narrowly confined to Ukraine and the Black Sea as long as the flow of energy between Russia and the EU continues unabated. Ukraine underscores the potential for volatility to surge from an already elevated base as news items interact with uncertainty about the Fed. We will continue to manage the ETF portfolio with a more tactical bent than we otherwise would. 2022 Rate Hike Expectations Have Gone Too Far 2022 Rate Hike Expectations Have Gone Too Far 2022 Rate Hike Expectations Have Gone Too Far Bottom Line: Russia’s movements of troops and materiel have been weighing on equity markets. Now that it has made its move, the bottom of the range may be near. Feature This is the first of a series of monthly reports devoted to the ETF portfolio we launched at the end of January. Each report will review the previous month’s performance, tracking the portfolio's relative return and highlighting its key contributors. More importantly, it will reassess our forward-looking views and situate them in an asset allocation/portfolio construction context. This monthly report will also be our primary vehicle for making portfolio adjustments, though we will make intra-month changes if market prices or our views change enough to merit them. In the immediate future, the conflict in Ukraine looms large. Russia’s full-scale incursion into Ukraine on February 24th roiled global financial markets, especially in Europe, with US equities executing a stunning reversal, exemplified by the high-beta NASDAQ, which fell 3% in overnight futures trading before recovering all the decline en route to a 3% gain in the live session. The wild action highlighted the potential for volatility to spike while investors are already on edge over unusually high inflation and the Fed’s attempts to contain it. We reiterate that we expect volatility will remain elevated this year and perhaps across the entire rate hiking cycle. Looking Ahead On a call last week, a client asked us if we were more confident or less confident in our views than we were on our quarterly webcast two weeks ago. Though no major new data had arrived in the interim (and Russia had not yet invaded Ukraine), we responded that our conviction level was unchanged to slightly higher, given the comfort we derived from our fixed income colleagues’ well-reasoned argument for why they think rates have peaked in the near term and our own analysis of the University of Michigan consumer sentiment survey respondents’ perceptions of inflation. The Ukraine conflict has the potential to push energy prices higher in the very near term, but it does not alter our six-to-twelve-month view. Chart 1Entering The Fourth Wave Of Persistently High Volatility? Entering The Fourth Wave Of Persistently High Volatility? Entering The Fourth Wave Of Persistently High Volatility? Chart 2A Whole Lot Of Dry Powder ... A Whole Lot Of Dry Powder ... A Whole Lot Of Dry Powder ... We are still constructive on financial markets and the economy, as well, though we expect that geopolitics may well provide a catalyst for rolling surges in the already elevated VIX (Chart 1). The escalation of the Ukraine conflict will temporarily preserve the geopolitical risk premium embedded in crude oil prices, but the evergreen commodity rule that high prices are the best cure for high prices will soon assert itself. Our Commodity & Energy Strategy team projects that oil producers will ramp up supply sufficient to dislodge the risk premium by the end of the year, taking Brent crude down to $85 a barrel, where it expects it will remain throughout 2023. While high oil prices are a tax on economic activity, their adverse effect on the US is mitigated by its status as the world’s largest oil producer. Our positive outlook for the US economy rests on our expectation that flush American households will begin drawing down their mountain of pandemic savings (Chart 2, bottom panel) now that COVID infections are less numerous (Chart 3, top panel) and less serious (Chart 3, bottom panel). As the pandemic wanes, households will regain their full range of consumption options, from dining out and in-person entertainment to travel and lodging. Our base-case outlook has them spending about half of their $2-plus trillion of pandemic savings, but we note that they can draw upon other pools of capital. Household net worth has surged at a record rate over the eight quarters of the pandemic as the value of financial assets and homes surged, and banks are eager to help consumers deploy their idle credit capacity to top up their buying power (Chart 4). Chart 3... Is Ready To Be Deployed Now That Omicron Is Out Of The Way ... Is Ready To Be Deployed Now That Omicron Is Out Of The Way ... Is Ready To Be Deployed Now That Omicron Is Out Of The Way Chart 4Banks Are Eager To Lend To Consumers Banks Are Eager To Lend To Consumers Banks Are Eager To Lend To Consumers Persistent inflation could erode some of that buying power while weighing on consumer sentiment. The Russia-Ukraine conflict has the potential to push food costs higher along with energy costs, as Ukraine is a top ten producer of both corn and wheat and Russia is a global wheat heavyweight, but emerging markets are likely to bear the brunt of higher agricultural commodity prices as the US and the EU are net exporters of both grains. As detailed below, we expect inflation will soon peak and begin decelerating at a rapid clip, so we do not expect higher prices to weaken the consumption tailwind, no matter what the Ukraine affair may bring. We continue to have very high conviction that the US will grow well above trend in 2022 and expect that S&P 500 earnings per share will grow in the mid-to-high single digits. Yields Have Backed Up Enough (For Now) We expect that volatility will remain elevated throughout this year and perhaps over the course of the Fed’s entire rate-hiking campaign as investors navigate an unfamiliar inflation backdrop and the Fed grapples with the challenges of normalizing monetary policy after a decade and a half of extraordinary accommodation. We have therefore recommended that investors consider adopting a more tactical approach to portfolio management and we are committed to following our own advice in the ETF portfolio. Although our cyclical view of interest rates has not changed – we expect they are ultimately headed higher than bond market participants do – we are persuaded by our fixed income colleagues’ argument that they’ve backed up too much too soon. We are therefore unwinding our below-benchmark duration positioning in the fixed income segment of our portfolio and tactically shifting to benchmark duration. Our colleagues cite several reasons for their call, but they all coalesce around the way that relentless upside inflation surprises have prompted aggressive rate hike expectations. They argue that market participants have overestimated how much the FOMC will hike the fed funds rate this year, as the overnight index swap curve is now pricing in about 150 basis points (bps) of hikes (Chart 5). That is well above the FOMC’s median 75-bps projection in December, and even though the official projection will rise at the March meeting, there is almost no chance that the committee’s guidance will be more hawkish than what the market is already discounting. Since the FOMC cannot surprise to the upside, rate hike expectations cannot push yields any higher for now. Chart 5Interest Rate Markets Have Gotten Ahead Of Themselves Interest Rate Markets Have Gotten Ahead Of Themselves Interest Rate Markets Have Gotten Ahead Of Themselves The uninterrupted run of upside US inflation surprises drove the bond market to ramp up its rate hike expectations, but we expect that US inflation will peak this spring and decelerate rapidly to less uncomfortable levels, even though they will remain well above the Fed’s 2% target. The Manufacturing ISM Prices Paid Index, which leads headline inflation by six months (Chart 6, middle panel), reflects the deceleration in commodity and other input prices that is already underway (Chart 6, top panel). The ISM Supplier Deliveries Indexes suggest that global supply chain pressures have already started to ease (Chart 6, bottom panel). Ukraine disruptions aside, our commodity and energy strategists see oil price momentum losing steam, with Brent crude falling to $85 per barrel in the second half of the year and holding at that level across 2023 (Chart 7). Chart 6Good Tidings From The ISM Survey ... Good Tidings From The ISM Survey ... Good Tidings From The ISM Survey ... ​​​​​ Chart 7... And Relief On The Oil Front ... And Relief On The Oil Front ... And Relief On The Oil Front As COVID recedes and people can resume typical day-to-day activities, consumer spending will continue to shift from goods to services (Chart 8). High-demand goods in categories subject to supply constraints have undergone a natural experiment in surge pricing. With supply at a deficit relative to demand, prices have risen to ration items like new automobiles to purchasers with the greatest time preference. Easing supply chain bottlenecks will help on the supply side of the equation and the new availability of services alternatives – attending live events instead of upgrading home theater and audio systems, going to the gym instead of buying home exercise equipment, taking a summer vacation instead of building a new backyard deck – will help relieve some of the upward pressure on demand. Chart 8When Demand Shifts To Services ... When Demand Shifts To Services ... When Demand Shifts To Services ... ​​​​​​ Chart 9... Inflation Will Ease ... Inflation Will Ease ... Inflation Will Ease A shift in spending patterns favoring services will allow headline inflation to move away from extreme double-digit goods inflation to merely elevated services inflation (Chart 9). Chart 10No One Left To Sell No One Left To Sell No One Left To Sell Our colleagues also expect that upward pressure on wages, which has been concentrated in service-sector positions at the low end of the scale, will ease as Omicron fades and workers are able to return to the labor force without fearing for their health. The tightening of financial conditions that has occurred as rates have backed up and equity prices have fallen will cool growth momentum and reduce the potential for overheating. With inflation soon peaking and longer-run inflation expectations having remained well anchored, the Fed will feel less pressure to hike rates according to markets’ accelerated timetable. Finally, Treasury market positioning is now so unbalanced to the short side that investors would appear to be nearly out of selling capacity to push yields higher (Chart 10). Bottom Line: We expect that Treasury yields will ultimately rise much higher than the bond market currently anticipates, but the forces that have pushed them sharply higher since early December are spent. The near-term path of least resistance for bond yields is to the downside and we are shifting to a tactically neutral duration position to prepare for it. Portfolio Changes We are leaving our current equity positioning intact, as it remains appropriate to overweight the energy, industrials and financials sectors while avoiding consumer staples and utilities and maintaining direct out-of-benchmark exposure to the S&P 500 Pure Value Index via RPV and to the S&P SmallCap 600 Index via IJR (please refer to Cyclical ETF Portfolio table on page 11). We are reducing our exposure to the 1- to 3-year segment of the Treasury curve by 200 bps (SHY) and to the 3- to 7-year segment by 60 bps (IEI) and increasing our exposure to the 7- to 10-year segment by 260 bps (IEF) to bring portfolio Treasury duration into balance with the benchmark. We are exiting LQDH, the rate-hedged investment-grade corporate bond ETF, and reallocating the proceeds to its unhedged LQD version to bring corporate bond duration into balance. Portfolio Performance Market volatility and equity declines over the past ten trading days have cut its alpha in half, but the risk-friendly cyclical ETF portfolio we introduced last month has nevertheless outperformed its benchmark by 18 basis points (“bps”) through last Thursday’s close. Our equity positioning accounted for most of the value-add (Chart 11). Rising yields were a significant tailwind given our short duration stance. They also supported our value and small-cap tilts and, to a lesser extent, our overweight position in financials. The surge in energy prices generously rewarded our energy equities overweight (XLE). Chart 11Direct Equity Sector Deviations March 2022 Cyclical ETF Portfolio Review March 2022 Cyclical ETF Portfolio Review Widening spreads since the beginning of the year were a headwind to our positioning within the fixed-income space (Chart 12). Our overweight to variable-rate preferred stocks (VRP) as an alternative to dearly priced bonds was the main detractor. Chart 12Fixed Income Deviations March 2022 Cyclical ETF Portfolio Review March 2022 Cyclical ETF Portfolio Review Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Cyclical ETF Portfolio March 2022 Cyclical ETF Portfolio Review March 2022 Cyclical ETF Portfolio Review

Executive Summary From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi The geopolitical “big picture” of Russia’s invasion of Ukraine is the deepening of the Russo-Chinese strategic partnership. While Russia’s economic and military constraints did not prohibit military action in Ukraine, they are still relevant. Most likely they will prevent a broader war with NATO or a total energy embargo of Europe. Still, volatility will persist in the near term as saber-rattling, aftershocks, and spillover incidents will occur this year.  Russo-Chinese relations are well grounded. Russia needs investment capital and resource sales, while China needs overland supply routes and supply security. Both seek to undermine the US in a new game of Great Power competition that will prevent global politics and globalization from normalizing. Tactically we remain defensive but buying opportunities are emerging. We maintain a cyclically constructive view. Favor equity markets of US allies and partners that are geopolitically secure. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.7% Bottom Line: Tactically investors should remain defensive but cyclically they should look favorably on cheap, geopolitically secure equity markets like those of Australia, Canada, and Mexico. Feature To understand the Russian invasion of Ukraine and the likely consequences, investors need to consider three factors: 1.  Why Russia’s constraints did not prohibit war and how constraints must always be measured against political will. 2.  Why Russia’s constraints will grow more relevant going forward, as the costs of occupation and sanctions take hold, the economy weakens, and sociopolitical pressures build. 3.  Why the struggle of the Great Powers will drive a Russo-Chinese alliance, whose competition with the US-led alliance will further destabilize global trade and investment. Russia’s Geopolitical Will Perhaps the gravest national security threat that Russia can face, according to Russian history, is a western military power based in the Ukraine. Time and again Russia has staged dramatic national efforts at great cost of blood and treasure to defeat western forces that try to encroach on this broad, flat road to Moscow. Putin has been in power for 22 years and his national strategy is well-defined: he aims to resurrect Russian primacy within the former Soviet Union, carve out a regional sphere of influence, and reduce American military threats in Russia’s periphery. He has long aimed to prevent Ukraine from becoming a western defense partner. Chart 1Russia Structured For Conflict From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi While Moscow faced material limitations to military action in Ukraine, these were not prohibitive, as we have argued. Consider the following constraints and their mitigating factors: Costs of war: The first mistake lay in assuming that Russia was not willing to engage in war. Russia had already invaded Ukraine in 2014 and before that Georgia in 2008. The modern Russian economy is structured for conflict: it is heavily militarized (Chart 1). Military spending accounts for 4.3% of GDP, comparable to the United States, also known for waging gratuitous wars and preemptive invasions. Financial burdens: The second mistake was to think that Moscow would avoid conflict for fear of the collapse of the ruble or financial markets. Since Putin rose to power in 2000, the ruble has depreciated by 48% against the dollar and the benchmark stock index has fallen by 57% against EMs. Each new crackdown on domestic or foreign enemies has led to a new round of depreciation and yet Putin remains undeterred from his long-term strategy (Chart 2). Chart 2Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Economic health: Putin’s foreign policy is not constrained by the desire to make the Russian economy more open, complex, advanced, or productive. While China long practiced a foreign policy of lying low, so as to focus on generating wealth that could later be converted into strategic power (which it is doing now), Russia pursued a hawkish foreign policy for the past twenty years despite the blowback on the economy. Russia is still an undiversified petro-state and total factor productivity is approaching zero (Chart 3). Chart 3Putin Doesn't Eschew Conflict For Sake Of Productivity Putin Doesn't Eschew Conflict For Sake Of Productivity Putin Doesn't Eschew Conflict For Sake Of Productivity ​​​​​​ Chart 4Putin Doesn’t Eschew Conflict For Fear Of Sanctions From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Western sanctions: Western sanctions never provided a powerful argument against Russian intervention into Ukraine. Russia knew all along that if it invaded Ukraine, the West would impose a new round of sanctions, as it has done periodically since 2014. The 2014 oil crash had a much greater impact on Russia than the sanctions. Of course, Russia’s overall economic competitiveness is suffering, although it is capable of gaining market share in exporting raw materials, especially as it depreciates its currency (Chart 4). Chart 5Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Public opinion: Surely the average Russian is not interested in Ukraine and hence Putin lacks popular support for a new war? True. But Putin has a strong record of using foreign military adventures as a means of propping up domestic support. Of course, opinion polls, which confirm this pattern, are manipulated and massaged (Chart 5). Nevertheless Russians like all people are highly likely to side with their own country in a military confrontation with foreign countries, at least in the short run. Over the long haul, the public will come to rue the war. Moscow believes that it can manage the domestic fallout when that time comes because it has done so since 2014. We doubt it but that is a question for a later time. Investors also need to consider Putin’s position if he did not stage ever-escalating confrontations with the West. Russia is an autocracy with a weak economy – it cannot win over the hearts and minds of its neighboring nations in a fair, voluntary competition with the West, the EU, and NATO. Russia’s neighbors are made up of formerly repressed Soviet ethnic minorities who now have a chance at national self-determination. But to secure their nationhood, they need economic and military support, and if they receive that support, then they inherently threaten Russia and help the US keep Russia strategically contained. Russia traditionally fights against this risk. Bottom Line: Investors and the media focused on the obstacles to Russian military intervention without analyzing whether there was sufficient political will to surmount the hurdles. Constraints Eroded None of the above suggests that Putin can do whatever he wants. Economic and military constraints are significant. However, constraints erode over time – and they may not be effective when needed. Europe did not promise to cancel all energy trade if Russia invaded: Exports make up 27% of Russian GDP, and 51% of exports go to advanced economies, especially European. Russia is less exposed to trade than the EU but more exposed than the US or even China (Chart 6). However, Russia trades in essential goods, natural resources, and the Europeans cannot afford to cut off their own energy supply. When Russia first invaded Ukraine in 2014, the Germans responded by building the Nord Stream pipeline, basically increasing energy cooperation. Russia concluded that Europeans, not bound to defend Ukraine by any treaty, would continue to import energy in the event of a conflict limited to Ukraine. Chart 6Putin Limits Conflict For Sake Of EU Energy Trade From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Chart 7Putin Limits Conflict For Sake Of Chinese Trade From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Russia substitutes China for Europe: As trade with the West declines, Russia is shifting toward the Far East, especially China (Chart 7). China is unlikely to reduce any trade and investment for the sake of Ukraine – it desperately needs the resources and the import-security that strong relations with Russia can provide. It cannot replace Europe – but Russia does not expect to lose the European energy trade entirely. (Over time, of course, the EU/China shift to renewables will undermine Russia’s economy and capabilities.) Ukraine is right next door: Aside from active military personnel, the US advantage over Iraq in 2002-03 was greater than the Russian advantage over Ukraine in 2022 (Chart 8). And yet the US got sucked into a quagmire and ultimately suffered political unrest at home. However, Ukraine is not Afghanistan or Iraq. Russia wagers that it can seize strategic territory, including Kiev, without paying the full price that the Soviets paid in Afghanistan and the US paid in Afghanistan and Iraq. This is a very risky gamble. But the point is that the bar to invading Ukraine was lower than that of other recent invasions – it is not on the opposite side of the world. ​​​​​​​Chart 8Putin Limits Conflict For Fear Of Military Overreach From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi Chart 9Putin Limits Conflict For Fear Of Military Weakness From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi NATO faces mutually assured destruction: NATO’s conventional military weight far surpasses Russia’s. For example, Russia, with its Eurasian Union, does not have enough air superiority to engage in offensive initiatives against Europe, even assuming that the United States is not involved. Even if we assume that China joins Russia in a full-fledged military alliance under the Shanghai Cooperation Organization (SCO), NATO’s military budget is more than twice as large (Chart 9). However, this military constraint is not operable in the case of Ukraine, which is not a NATO member. Indeed, Russia’s aggression toward Ukraine stems from its fear that Ukraine will become a real or de facto member of NATO. It is the fear of NATO that prompted Russia to attack rather than deterring it, precisely because Ukraine was not a member but wanted to join. Bottom Line: Russia’s constraints did not prohibit military action because several of them had eroded over time. NATO was so threatening as to provoke rather than deter military action. Going forward, Russia’s economic and military constraints will prevent it from expanding the war beyond Ukraine.  Isn’t Russia Overreaching? Yes, Russia is overreaching – the military balances highlighted in Charts 8 and 9 above should make that plain. The Ukrainian insurgency will be fierce and Russia will pay steep costs in occupation and economic sanctions. These will vitiate the economy and popular support for Putin’s regime over the long run. Chart 10The West Is Politically Divided And Vulnerable From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi The West is also vulnerable, however, which has given rise to a fiscal and commodity cycle that helps to explain why Putin staged his risky invasion at this juncture in time: The US and West are politically divided. Western elites see themselves as surrounded by radical parties that threaten to throw them out and overturn the entire political establishment. Their tenuous grip on power is clear from the thin majorities they hold in their legislatures (Chart 10). Nowhere is this clearer than in the United States, where Democrats cannot spare a single seat in the Senate, five in the House of Representatives, in this fall’s midterm elections, yet are facing much bigger losses. Russia believes that its hawkish foreign policy can keep the democracies divided.​​​​​​​ Elites are turning to populist spending: Governments have adopted liberal fiscal policies in the wake of the global financial crisis and the pandemic. They are trying to grow their way out of populist unrest, debt, and various strategic challenges, from supply chains to cyber security to research and development (Chart 11). China is also part of this process, despite its mixed economic policies. The result is greater demand for commodities, which benefits Russia.    Elites are turning to climate change to justify public spending: Governments, particularly in Europe and China, are using fears of climate change to increase their political legitimacy and launch a new government “moonshot” that justifies more robust public investment and pump-priming. The long-term trend toward renewable energy is fundamentally threatening to Russia, although in the short term it makes Russian natural gas and metals all the more necessary. Germany especially envisions natural gas as the fossil-fuel bridge to a green future as it has turned against both nuclear power and coal (Chart 12). Russian aggression will provoke a rethink in some countries but Germany, as a manufacturing economy, is unlikely to abandon its goals for green industrial innovation. Chart 11Politically Vulnerable States Need Fiscal Stimulus Politically Vulnerable States Need Fiscal Stimulus Politically Vulnerable States Need Fiscal Stimulus ​​​​​​ Chart 12The West Reluctant To Abandon Climate Goals From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Proactive fiscal and climate policy motivate new capex and commodity cycle: The West’s attempt to revive big government and strategic spending will require vast resource inputs – resources that Russia can sell at higher prices. The new commodity cycle gives Russia maximum leverage over Europe, especially Germany, at this point in time (Chart 13). Later, as inflation and fiscal fatigue halt this cycle, Russia will lose leverage. Chart 13Commodity Cycle Gives Russia Advantage (For Now) Commodity Cycle Gives Russia Advantage (For Now) Commodity Cycle Gives Russia Advantage (For Now) Meanwhile Russia’s economic and hence strategic power will subside over time. Russia’s potential GDP growth has fallen since the Great Recession as productivity growth slows and the labor force shrinks (Chart 14). Chart 14Future Will Not Yield Strategic Opportunities For Russia Future Will Not Yield Strategic Opportunities For Russia Future Will Not Yield Strategic Opportunities For Russia ​​​​​​ Chart 15Younger Russians Not Calling The Shots (But Will Someday) From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi In short, the Kremlin has chosen the path of economic austerity and military aggression as a means of maintaining political legitimacy and achieving national security objectives. Western divisions, de-carbonization, the commodity cycle, and Russia’s bleak economic outlook indicated that 2022 was the opportunity to achieve a pressing national security objective, rather than some future date when Russia will be less capable relative to its opponents. In the worst-case scenario – not our base case – the invasion of Ukraine will trigger an escalation of European sanctions that will lead to Russia cutting off Europe’s energy and producing a global energy price shock. And yet that outcome would upset US and European politics in Russia’s favor, while Putin would maintain absolute control at home in a society that is already used to economic austerity and that benefits from high commodity prices. Note that Putin’s strategy will not last forever. Ukraine will mark another case of Russian strategic overreach that will generate a social and political backlash in coming years. While Putin has sufficient support among older, more Soviet-minded Russians for his Ukraine adventure, he lacks support among the younger and middle-aged cohorts who will have to live with the negative economic consequences (Chart 15). The entire former Soviet Union is vulnerable to social unrest and revolution in the coming decade and Russia is no exception. The Russo-Chinese Geopolitical Realignment Chart 16From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From a broader, geopolitical point of view, Russia’s invasion of Ukraine drives another nail into the coffin of the post-Cold War system and hyper-globalization. Russia is further divorcing itself from the western economy, with even the linchpin European energy trade falling victim to renewables and diversification. The US and its allies are imposing export controls on critical technologies such as semiconductors against Russia to cripple any attempts at modernization. The US is already restricting China’s access to semiconductors and from now on is locked into a campaign to try to enforce these export controls via secondary sanctions, giving rise to proxy battles in countries that Russia and China use to circumvent the sanctions. Russia will be forced to link its austere, militarized, resource-driven economy to the Chinese economy. Hence a major new geopolitical realignment is taking place between the US, Russia, and China, on the order of previous realignments since World War II. When the Sino-Soviet communist bloc first arose it threatened to overwhelm the US in economic heft and dominate Eurasia. This communist threat drove the US to undertake vast expeditionary wars, such as in South Korea and Vietnam. These were too costly, so the US sought economic engagement with China in 1972, which isolated the Soviet Union and ultimately helped bring about its demise. Yet China’s economic boom predictably translated into a strategic rise that began to threaten US preeminence, especially since the Great Recession. Today Russia and China have no option other than to cooperate in the face of the US’s increasingly frantic attempts to preserve its global status – and China’s economic growth and technological potential makes this alliance formidable (Chart 16). In short, the last vestiges of the “Nixon-Mao” moment are fading and the “Putin-Xi” alignment is already well-established. Russia cannot accept vassalage to China but it can make many compromises for the sake of strategic security. Their economies are much more complimentary today than they were at the time of the Sino-Soviet split. And Russia’s austere economy will not collapse as long as it retains some energy trade with Europe throughout the pivot to China. In turn the US will attempt to exploit Russian and Chinese regional aggression as a basis for a revitalization of its alliances. But Europe will dampen US enthusiasm by preserving economic engagement with Russia and China. The EU is increasingly an independent geopolitical actor and a neutral one at that. This environment of multipolarity – or Great Power Struggle – will define the coming decades. It will ensure not only periodic shocks, like the Ukraine war, but also a steady undercurrent of growing government involvement in the global economy in pursuit of supply security, energy security, and national security. Competition for security is not stabilizing but destabilizing. Hyper-globalization has given way to hypo-globalization, as regional geopolitical blocs take the place of what once promised to be a highly efficient and thoroughly interconnected global economy. Investment Takeaways Tactically, Geopolitical Strategy believes it is too soon to go long emerging markets. Russia is at war, China is reverting to autocracy, and Brazil is still on the path to debt crisis. Multiples have compressed sharply but the bad news is not fully priced (Chart 17). The dollar is likely to be resilient as the Fed hikes rates and a major European war rages. Europe’s geopolitical and energy insecurity will weigh on investment appetite and corporate earnings. American equities are likely to outperform in the short run. Chart 17Investors Should Not Bet On Russian And European Equities In This Context Investors Should Not Bet On Russian And European Equities In This Context Investors Should Not Bet On Russian And European Equities In This Context ​​​​​ Chart 18Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets ​​​​​​ Cyclically, global equities outside the US, and pro-cyclical assets offer better value, as long as the war in Ukraine remains contained, a Europe-wide energy shock is averted, and China’s policy easing secures its economic recovery. While European equities will snap back, Europe still faces structural challenges and eastern European emerging markets face a permanent increase in geopolitical risk due to Russian geopolitical decline and aggression. Investors should seek markets that are both cheap and geopolitically secure – namely Australia, Canada, and Mexico (Chart 18). We are also bullish on India over the long run.    Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Given that a sustainable business cycle acceleration in China is unlikely in the short term, onshore government bond yields will likely drop further. In the long run, odds are that Chinese government bond yields will drop below US Treasury yields. For domestic asset allocators, we continue to recommend overweighting government bonds over stocks for now. The excess return of corporate bonds is driven by the corporate profit cycle. On a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. Bottom Line: Given our view that a meaningful growth recovery in China will only be a theme for the second half of this year, onshore asset allocators should continue favoring corporate credit over stocks and government bonds over corporate bonds. The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Feature In this report we (1) elaborate on our outlook for Chinese government and corporate bonds and (2) offer a framework for understanding how asset allocation for fixed-income (government and corporate bonds) and multi-asset portfolios (comprised of fixed-income plus equities) should be implemented. Domestic Government Bonds Chart 1Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend The risk-reward profile of Chinese domestic government bonds remains attractive. Chinese government bond yields have been declining,  bucking the global trend of surging government bond yields (Chart 1, top panel). Odds are that Chinese bond yields will drop further, both cyclically and structurally: In contrast with the Americas and Europe, China’s consumer price inflation has remained subdued. Its core, trimmed mean and headline inflation rates have remained low (Chart 2). The ongoing growth slump will cap core inflation in China at around 1%, allowing monetary authorities to lower interest rates further. Real bond yields in China remain well above those in the majority of DM (Chart 1, bottom panel). Hence, risk-free bonds in China offer value. As to the Chinese stimulus and business cycle, the recent pickup in Chinese credit numbers has been entirely due to local government bond issuance. After excluding local government bonds, credit growth and its impulse have not improved (Chart 3). While infrastructure spending will pick up in the coming months (given large special bond issuance), sentiment among consumers and private companies remains downbeat and local government budgets are severely impaired by the collapse in revenues from land sales. Hence, it will take some time before a boost in infrastructure activity lifts broader business and consumer sentiment such that a sustainable economic recovery can take hold. Chart 2Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chart 3Recent Credit Improvement Is Entirely Due to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance The special bond quota for Q1 stands at RMB 1.46 trillion and is equivalent to 28% of local government aggregate quarterly revenue. Even though the special bond issuance in Q1 is massive, it will be largely offset by the drop in local governments’ land sales revenue. The latter is shrinking and makes up more than 40% of local government aggregate revenues. In brief, strong headwinds from the property market in the form of shrinking land sales might counteract the increase from front-loaded special bond issuance in Q1 2022. As to real estate construction, funding for property developers is down dramatically from a year ago (Chart 4). In the absence of financing, real estate developers will shrink construction volumes in the months ahead. Chart 5Debt Service Burden For Chinese Enterprises And Households Is High Debt Service Burden For Chinese Enterprises And Household Is High Debt Service Burden For Chinese Enterprises And Household Is High Chart 4Property Completions Will Roll Over Property Completions Will Roll Over Property Completions Will Roll Over   Structurally, high enterprise and household debt levels in China amid slumping incomes mean that borrowing costs should drop to facilitate debt servicing. BIS estimates that debt service costs for the private sector (enterprises and households) in China are 21% of disposable income, much higher than in many other economies (Chart 5). Finally, China’s large and persistent current account surpluses mean that the nation is a major international creditor rather than a debtor. Thus, China does not need to offer high yields to attract foreign capital. Structurally speaking, foreign fixed-income inflows into Chinese domestic bonds will likely continue. Chart 6Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Bottom Line: Bond yields will likely drop further as a sustainable business cycle acceleration in China is unlikely in the short term. Chart 6 illustrates that the total social financing impulse leads bond yields by nine months and a cyclical bottom in yields will probably occur a few months from now. In the long run, Chinese government bonds yields will likely drop below US Treasury yields. Onshore Corporate Bonds The proper measure of corporate bond performance is excess return over similar government bonds (herein excess return). The basis for using excess return instead of total return for corporate bonds is because investors can attain government bond return by purchasing them outright. Essentially, investors prefer corporate bonds over government bonds because of credit spreads. Hence, a corporate bond performance assessment – whether in absolute terms or relative to other asset classes – should be based on excess return. In China, the excess return on onshore corporate bonds1 usually moves in tandem with the business cycle and government bond yields. In particular: The excess return of corporate bonds is positive during periods of growth acceleration and negative during slowdowns (Chart 7, top panel). The middle panel of Chart 7 illustrates that the excess return of corporate bonds correlates with analysts’ net EPS revisions for onshore listed companies. This confirms the above point that corporate bonds correlate with the profit/business cycle. Significantly, even though industrial profit growth is not yet negative (Chart 8, top panel), earnings in commodity-user industries have crashed (Chart 8, bottom panel).  This explains the negative excess return for onshore corporate bonds in the past 12 months. Chart 7The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Chart 8Corporate Profit Cycle: Mind The Divergence Corporate Profit Cycle: Mind The Divergency Corporate Profit Cycle: Mind The Divergency Furthermore, the excess return of corporate bonds declines and rises with interest rate expectations (Chart 7, bottom panel). As the outlook for corporate profits remains sour, fixed-income investors should continue to favor government bonds over corporate bonds. Now, how do corporate bonds perform versus stocks? What drives their relative performance? To compare stock performance to corporate bond excess return, one should adjust for volatility. In other words, share prices are much more volatile than the excess return on corporate bonds. Hence, during risk-on periods equities always outperform corporate bonds and vice versa. Chart 9The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical Chart 9 demonstrates that even on a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. In short, the performance of stocks over corporate bonds is very pro-cyclical. Bottom Line: The excess return of corporate bonds is driven by corporate revenue and profits rather than by interest rate expectations. Getting China’s business cycle right is critical to the allocation between government and corporate bonds in fixed-income portfolios and to the allocation between corporate bonds and equities in multi-asset portfolios. Given our view that a meaningful growth recovery in China will only be a theme in the second half of this year, onshore asset allocators should continue favoring corporate bonds over stocks and government bonds over corporate credit. Offshore Corporate Bonds What drives the excess return of Chinese USD corporate bonds in absolute terms as well as versus Chinese non-TMT investable stocks2 and onshore corporate bonds? Given that the offshore corporate bond universe is dominated by property developers, their excess return correlates with perceived risks to the mainland property market in general and the financial health of property developers in particular (Chart 10, top panel). Property developers are very overleveraged, their sales are shrinking and their financing has dried up. Yet, authorities are compelling them to complete construction of their pre-sold housing. Property developers will therefore continue to experience financial distress. Odds are that bond prices of corporate developers – both investment grade and high yield - will continue falling (Chart 10, middle and bottom panels). Chart 11Investable Stocks Vs. Offshore Corporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Chart 10A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds On a volatility-adjusted basis, non-TMT investable stocks outpace the excess return of offshore corporate bonds during periods of growth improvement and underperform during growth slowdowns (Chart 11, top panel). The same pattern holds true when it comes to the performance of offshore corporate bond versus the aggregate MSCI Investable equity index (including TMT stocks) (Chart 11, bottom panel). The credit cycle leads the business cycle and, thereby, it leads these financial market trends. Bottom Line: The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Chinese offshore corporate bonds will continue underperforming EM corporate bonds as well as Chinese onshore corporate bonds. Investment Recommendations Investors often read market signals across asset classes to gauge which market moves will persist and which ones will be short-lived.  In this regard, we have two observations for Chinese onshore markets: Chart 12Moving In Tandem Moving In Tandem Moving In Tandem The sustainability of an equity rally is higher when it is confirmed by rising excess returns of corporate bonds and rising government bond yields (Chart 12). Presently, there is no strong signal to switch from government bonds to either corporate bonds or stocks. Unfortunately, the yield curve in China does not correlate with its business cycle and, hence, cannot be used as a tool in macro analysis.  Our key investment conclusions are: For fixed-income investors, we continue to recommend receiving 10-year swap rates in China and for dedicated EM local currency bond managers to remain overweight China. The renminbi has been firm versus the US dollar despite a considerable narrowing in the interest rate differential between China and the US. In the long run, the real interest rate differential between China and the US will drive the exchange rate, and it will favor the RMB. While US real bond yields might rise relative to Chinese bond yields in the coming months, triggering a period of yuan softness, it will prove to be transitory. The basis is that the Federal Reserve is very sensitive to asset prices. As US share prices decline and corporate spreads widen, the central bank will eventually turn dovish and will lag behind the inflation curve. When a central bank falls behind the inflation curve, real rates stay low and its currency depreciates. Chart 13China’s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio For domestic asset allocators, we continue to recommend favoring government bonds over stocks (Chart 13). Within fixed-income portfolios, investors should overweight government bonds over corporate bonds. Finally, corporate bonds will fare better than equities in the near term. In a few months there will be an opportunity to shift these positions.  More aggressive stimulus from authorities and aggressive property market relaxation measures will create conditions for an improvement in domestic demand. Finally, the risk-reward profile for offshore USD corporate bonds remains unattractive. Chinese offshore corporate credit will continue underperforming EM USD corporate credit as well as Chinese onshore corporate bonds.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    Due to the lack of excess return data from the index provider (Bloomberg Barclays onshore bond indexes), we calculated the excess return on onshore corporate bonds as the ratio of the total return on the corporate bond index divided by the total return on the government bond index. This measure is not ideal as it does not account for duration mismatches between the corporate and government bond indexes. However, the key conclusions of this report will hold true for the duration-adjusted excess return not least because this framework is valid for financial markets in the US and Europe. 2    The reason to compare it to non-TMT (technology, media and telecommunication, i.e., Chinese tech and internet stocks) is that offshore corporate bond issuers are largely old economy industries.

Executive Summary US Policy Uncertainty Rises With ERP US Policy Uncertainty Rises With ERP US Policy Uncertainty Rises With ERP The US is witnessing a rolling political crisis that will escalate again in the 2022-24 election cycle and presents a tail-risk of constitutional fracture. However, fundamental economic, constitutional, and geopolitical factors are structurally positive. US domestic political risk is not greater than foreign geopolitical risk affecting other major markets like Europe. The US faces challenges to maintain its competitive and technological edge. But the combination of a vibrant private sector and increasingly proactive fiscal policy give reason for optimism. The 2022-24 macroeconomic and political cycles will likely cause an increase in policy uncertainty and hence the equity risk premium – but foreign markets face even greater risks. Recommendation (Tactical) Inception Level Initiation Date Stop Loss Long DXY   Feb 23/2022   Bottom Line: Go tactically long US dollar (DXY) on the anticipation that US and especially global policy uncertainty and political risk premiums will rise. Feature With President Joe Biden’s approval rating falling to a new net low of -13%, investors are starting to ask about the future of American politics once again. It is highly likely that Democrats will lose control of Congress this fall, setting up a tumultuous 2024 election cycle. With political polarization at historic highs, it is worth asking whether US policy uncertainty will inject a risk premium into US equities. Our answer is yes, uncertainty and the risk premium will rise. But the US also contains fundamental strengths, especially relative to other major markets. With geopolitical risk rising for Europe as Russia engages in new military adventures, the US market will remain attractive over the long run. Natural Advantages Any fundamental assessment of US capability should begin with its people. The US working-age population continues to grow, while that of Europe and China has started to plateau or decline (Chart 1). China’s working population is four times bigger than that of the US, so if China can manage its transition to a higher-wage economy (i.e. if it can maintain productivity growth) then it can compete for global investment capital. But the US’s continued labor force growth, despite social change and political instability, suggests that the US will not follow Japan and Europe into sluggish trend growth, unless sharp curbs on immigration are put into place. The maxim that “the people are the riches of a nation” is only true if economic opportunity and job creation are sufficient. People need access to capital to become more productive. Europe has the largest capital stock in the world, at $100,000 per capita, compared to the US’s $71,000 and China’s $33,000. But Europe’s capital stock has been flat-to-down since the Great Recession. China’s capital stock is rising rapidly and has a lot further to go given its low level. But the country also faces a difficult transition to a new economic model and a debt-deleveraging process that may slow down the pace of capital deepening in the coming years, forcing the government to step in and promote capital projects (Chart 2). Meanwhile the US’s capital stock continues to grow steadily.  Chart 1The People Are The Riches Of A Nation... The People Are The Riches Of A Nation... The People Are The Riches Of A Nation... Chart 2...As Long As The People Are Not Starved Of Capital ...As Long As The People Are Not Starved Of Capital ...As Long As The People Are Not Starved Of Capital Since the shale boom the US has become nearly energy self-sufficient and now produces 20% of global oil and fuel. This development is a blessing from an economic and national security perspective. But it also poses the risk of a kind of resource curse, in which the US could lack the motivation to pioneer renewable energy technology. Currently the US only produces 4% of the world’s renewable energy, a share that has been declining. Europe and China are both energy import-dependent, which is a national security vulnerability, and they will continue to invest in renewable solutions to improve their energy security (Chart 3). Russian aggression will motivate Europe to go down this path, whereas China will go down this path for fear of American strategic containment. For now, however, the US is energy self-sufficient while technologically capable of advancing in renewable energy. The US has a range of structural problems: rising income inequality, extreme political polarization, and a policy turn away from globalization over the past 20 years. However, these problems have not weighed on GDP per capita growth. Of course, the greatest strides in GDP per capita are occurring in the developing world: China and India show the most promise. But the US’s GDP per capita is still growing at an annual average rate of 3%, putting it alongside Germany and ahead of the much less developed Brazil (Chart 4). Germany did not see anywhere near as big of increases in inequality and polarization and is still generally committed to globalization, yet its GDP per capita growth is about the same as the US’s, despite faster US population growth. Chart 3North America's Natural Resource Blessing North America's Natural Resource Blessing North America's Natural Resource Blessing Chart 4Does Political Instability Harm Productivity? Does Political Instability Harm Productivity? Does Political Instability Harm Productivity? Partisanship Means Big Government None of the above benefits have been reversed by the US’s historic increase in political polarization and partisanship over the past three decades. Make no mistake, the latter trends are harmful and could weigh on US stability and productivity in coming years, primarily through deteriorating fiscal management. But so far their bad effects have been contained. The two US political parties have won control of the White House, the Senate, and the House of Representatives a roughly equal number of times. While Republicans have a larger regional presence, across the 50 states, and tend to perform better in the Electoral College and the Senate, this advantage is very slight judging by the number of electoral victories. Meanwhile Democrats have a larger popular presence and perform better in the House of Representatives but this advantage is also slight (Chart 5). The two parties are evenly balanced, which is one explanation for why they compete so viciously for marginal victories. But it also prevents either party from achieving absolute power and distorting or corrupting American bureaucracy and corporate structures to perpetuate single-party rule. Chart 5An Even Balance Of Power Between The Parties The US's Rolling Political Crisis The US's Rolling Political Crisis The size of the federal government fluctuates within a fairly low and narrow range. Federal government receipts hovered around 16% of GDP in the 1950s-60s, peaked at 20.4% in 2000, and today stand right in the middle of this post-war range at 18.5%. Major increases in revenue follow the business cycle and it is rare that Democrats manage to raise taxes enough to have a substantial impact. This point is clear from looking at periods when Democrats controlled both the House of Representatives and the White House (shaded areas in Chart 6): the large increases in tax take mostly coincide with economic growth spurts. It is conceivable that the Biden administration will raise a minimum corporate tax this year via the budget reconciliation process, but the odds of that have been falling and it will not change the pattern in this chart, which shows rising revenue relative to GDP as the economy recovers but is not likely to match what was seen in the late 1990s. From the perspective of federal government spending, the growth in the size of government is clearer, rising from the post-war 15% of GDP to today’s 25% of GDP, with a pronounced structural uptrend. Republicans rarely control both the White House and the House of Representatives and only in the 1950s did they reduce spending outright. The past two Republican administrations presided over large increases in spending, while also capping revenue via tax cuts (Chart 7). Chart 6US Federal Revenue Does Not Change Much Over Time US Federal Revenue Does Not Change Much Over Time US Federal Revenue Does Not Change Much Over Time Chart 7US Federal Spending Does Not Change Much Over Time US Federal Spending Does Not Change Much Over Time US Federal Spending Does Not Change Much Over Time Thus in America’s highly polarized and populist political scene, Republicans fail to cut spending while Democrats fail to increase taxes. The takeaway is that budget deficits will remain structurally large. The political outlook reinforces this point as it promises a return to congressional gridlock. Historically speaking, Biden’s net negative approval rating implies that Democrats will lose 40 seats in the House of Representatives and 4 seats in the Senate this fall. It is unlikely that Democratic fortunes will improve much between now and this November given that midterm elections almost always punish the ruling party and midterm voters tend to make up their minds early in the year. Moreover the ruling party’s ailments are not easily reversed: headline inflation is running at 7.5%, crime and immigration are growing at historic rates, while foreign policy challenges will likely feed the narrative that the Biden administration is weak on the global stage. The likelihood of congressional gridlock from 2022-24 (and maybe beyond) entails that future increases in fiscal spending will be automatic, through lack of entitlement reform, rather than through grandiose new spending programs, which will not pass into law. As such, “Big Government” is back but it is still “limited government” in the US tradition – i.e. limited big government. Neither party has a blank check or dominates for long. And if anything a period of fiscal normalization (or pseudo-normalization) is on the horizon. Constitutional And Geopolitical Advantages The balance of the parties is not accidental but essential to the American constitutional system. This system is based on the tradition of “mixed” or “balanced” constitutionalism, which developed in ancient Greece and Rome and came to the Americas via the United Kingdom. The system can be discussed in philosophical or ideological terms but it is rooted in real, physical, institutional power. The tradition begins with great philosophers like Plato and Aristotle but is perhaps best illustrated by the Greek historian Polybius. Polybius observed a violent historical cycle that ceaselessly shifted from despotism to oligarchy to the tyranny of the masses to anarchy and finally back to despotism. He argued that the Roman constitution, by mingling the different social classes (the leaders, the elite, and the masses), could produce a durable constitutional order that would prolong the time period until the state decayed and collapsed. We call this the “Polybius Solution” (Diagram 1). Diagram 1The Polybius Solution The US's Rolling Political Crisis The US's Rolling Political Crisis The US constitution is successful because, like several of the oldest European constitutions, it mixes the different social classes and sources of power so that the leaders, elites, and masses each have a share in the political system and no single group can predominate and overwhelm the others. It is an extra benefit that the US constitution is one of the longest continually operating constitutions in the world, since the long fortification of the system in practice helps provide sociopolitical and economic stability, whereas the ideas themselves are not well taught or understood (Table 1). The fact that the constitution is written in a single document is useful but not decisive, as the British constitution similarly provides stability over long periods of change and upheaval both at home and abroad. Table 1The Balanced Constitution The US's Rolling Political Crisis The US's Rolling Political Crisis Investors should not mistake this constitutional system merely for a set of preferential ideas. Opinions change very easily. But it is physically difficult for ruling classes to take away rights and privileges that the masses of people have been given. Thus the mixture of constitutional powers is based in political realism, not idealism. The US constitution operates not because Americans are more well-meaning, educated, civic-minded, altruistic, or enlightened than others. It operates because the oligarchy is not powerful enough to disenfranchise the democracy, while the democracy is not powerful enough to purge the oligarchy. The government leaders themselves (the president, the lawmakers, the career bureaucrats, etc) are not powerful enough to suspend term limits and stay in power forever. Nor have they been able to ally with either the oligarchy or the democracy closely enough to permanently exclude the other one from its share of power within the system. There is a clear and present danger that the constitutional system could come under too much strain and fracture amid recent power struggles among the American social classes. The struggles between the classes have intensified since the fall of the Soviet Union (which deprived America of a common enemy) and especially the Great Recession (which provoked populist democratic movements). Some fear that a president could turn into an autocrat and refuse to yield power, others fear that the oligarchic faction could steal elections or manipulate the legal system, others fear that the democratic faction could steal elections or ride roughshod over legal procedures. Of these risks, the risk of autocracy is the lowest, while the risk of institutional corruption or electoral manipulation or majoritarian rule-breaking are the highest. Certainly political risk and policy uncertainty will rise from current levels over the 2022-24 election cycle, which promises to be extremely disruptive. However, there are three reasons to hold the baseline view that the US political structure will remain stable enough to sustain economic productivity over the coming years, despite enormous upheaval on the cyclical level of politics. The US remains secure from invasion, while provoked to meet rising geopolitical challenges. Neither Canada nor Mexico poses a fundamental threat to US national security – the US is capable of militarizing the borders, however undesirable – and the US is inaccessible to more distant enemies due to the tyranny of distance across the Atlantic and Pacific oceans. Yet the resurgence of Russia and the rise of China are likely to present common external rivals around which America’s elites will attempt to galvanize public opinion to maintain national security and keep themselves in office. Because elections still tend to swing on historically critical regions, such as the Midwestern heartland, politicians will need to pursue some degree of economic nationalism to stay in power (Map 1). Map 1USA: Splendid Isolation? The US's Rolling Political Crisis The US's Rolling Political Crisis The US continues to benefit from a “brain drain” of talented foreign immigrants and will keep that door open if and when it curbs immigration more broadly. Immigration flows into the US are typically robust according to various indicators, including the numbers of newly naturalized citizens, which is itself an indicator of the US’s abiding advantages (Chart 8). The global pandemic caused a decline that is quickly rebounding. Immigration is one of the major outstanding sources of power struggle between the US political factions. It will become a centerpiece of the 2022-24 election cycle. The outcome is unclear. But general American attitudes toward immigration are not hostile, while elite attitudes favor immigration. Therefore whatever government policy finally emerges, it will likely preserve the US’s national interest of continuing to import global talent . Chart 8People Voting With Their Feet The US's Rolling Political Crisis The US's Rolling Political Crisis The US’s chronic trade imbalance generated a new policy consensus in favor of strengthening American competitiveness. The US pursued a policy of globalization and de-industrialization for decades but it became untenable in the wake of the Great Recession, which spawned a populist backlash. The Biden administration has largely coopted the Trump administration’s hawkish approach to trade. While US trade and current account deficits will remain very large for the foreseeable future, reflecting a fundamental imbalance of savings relative to investment (Chart 9), nevertheless the US will undertake targeted policies to improve supply chain resilience and domestic high-tech competitive edge. The Congress’s likely passage of the American Competes Act of 2022 exemplifies the new bipartisan consensus around the need to invest in American industrial and technological capabilities so as to better compete with great powers overseas (Table 2). Chart 9US Competitiveness Waning? People Voting With Their Feet People Voting With Their Feet Table 2US Bipartisan Consensus On Restoring Competitiveness The US's Rolling Political Crisis The US's Rolling Political Crisis By contrast, other regions face greater geopolitical threats to their homelands and greater difficulties coping with hypo-globalization. Europe’s strategic vulnerability to Russia will dampen investment sentiment and risk appetite. Russia’s economic trajectory has suffered since 2014 and its ongoing conflict with the West will result in isolation and lower productivity. China will see rising tensions with its neighbors due to its economic transition, emerging protectionism, and its need to become more assertive for the sake of supply security. By contrast the US is relatively insulated. Investment Takeaways The US’s economic, constitutional, and geopolitical advantages are structural positives. Rising domestic policy uncertainty over the 2022-24 election cycle might overshadow these positives temporarily, but they are likely to persist over the long run. Increasing geopolitical risks abroad suggest that domestic American policy uncertainty is likely to be overrated. Great power competition – stemming from geopolitical risks – will fuel capital spending among the major nations as well as research and development investments. In this respect the United States faces challenges to maintain its competitive edge. But it is still the leader and the combination of a vibrant private sector and an increasingly proactive public sector are positive (Chart 10). Are the US’s structural advantages already priced? To a great extent, yes. The US equity risk premium today stands at 300 basis points, compared to 660 in Europe and 570 in China. And yet global geopolitical risk, highlighted by Russia’s escalating conflict with the West, suggest that this divergence can get worse before it gets better. We expect the 2022-24 election cycle to cause an increase in policy uncertainty and the political risk premium. But as things stand the increase in uncertainty and risk premiums abroad will be even greater (Chart 11). Chart 10US Investing In The Future? US Investing In The Future? US Investing In The Future? Chart 11US Stocks Priced The Good News? US Stocks Priced The Good News? US Stocks Priced The Good News?       Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix The US's Rolling Political Crisis The US's Rolling Political Crisis Table A3US Political Capital Index The US's Rolling Political Crisis The US's Rolling Political Crisis Chart A1Presidential Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Chart A2Senate Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A4APolitical Capital: White House And Congress The US's Rolling Political Crisis The US's Rolling Political Crisis Table A4BPolitical Capital: Household And Business Sentiment The US's Rolling Political Crisis The US's Rolling Political Crisis Table A4CPolitical Capital: The Economy And Markets The US's Rolling Political Crisis The US's Rolling Political Crisis Footnotes  

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing Global Inflation Pressures Easing Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak Goods Inflation Should Soon Peak ​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply There Are Still Pockets Of Available US Labor Market Supply ​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions Fed Hawkishness Has Already Tightened Financial Conditions ​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive Not The Best Time For The Fed To Be More Aggressive ​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Five Reasons To Tactically Increase US Duration Exposure Now Five Reasons To Tactically Increase US Duration Exposure Now Tactical Overlay Trades

Executive Summary The ultimate inflation anchor is unit labor costs. If relative price shocks cause employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. US unit labor costs have been rising rapidly, which indicates that US inflation is becoming pervasive and entrenched (Chart of the week). The Fed is facing an acute dilemma that it has not encountered in the last 35 years or so: It either needs to slow growth materially to contain inflation or allow inflation to proliferate. The Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from the current levels. Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Bottom Line: The Fed and equity markets are on a collision course: The Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Feature In a report we published a year ago titled Riding A Tiger, we stated that “the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger… Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount.” We also contended that “in any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation… Odds are that the US will experience asset bubbles and inflation in the real economy.” Riding a tiger was indeed fun but now it is time for US policymakers to dismount. Yet, exiting the era of super easy monetary and fiscal policies will not be without costs and considerable financial market turbulence. Are the Fed and financial markets heading into a collision in the fog of inflation? Transitory Versus Persistent Inflation Chart 1US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US inflation has become broad-based.1 Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation have risen substantially (Chart 1).  Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor cost are calculated as nominal wages divided by productivity (the latter is output per hour per employee). As long as unit labor costs are not rising considerably, sharp price increases in several types of goods do not entail genuine inflation and central banks should not tighten aggressively. However, when unit labor costs are escalating, odds are that higher inflation could become entrenched and persistent. The importance of wages stems from the fact that labor compensation makes up the largest share of costs for the majority of industries. Consequently, rising unit labor costs squeeze profit margins. When this transpires, businesses try to pass on rising costs to customers. Provided that robust wage growth propels consumer demand, companies often succeed in raising their prices. Chart 2US Wages Are Rising Rapidly US Wages Are Rising Rapidly US Wages Are Rising Rapidly In turn, inflation erodes the purchasing power of wages, and employees demand substantial pay raises. When revenues are strong, employers typically accommodate employees’ claims for higher compensation, and a wage-price spiral emerges. These dynamics are presently unfolding in the US. US wage growth has reached multi-decade highs of 4.5-5.5% (Chart 2). Plus, the high and climbing quit rate points to further wage acceleration (Chart 3). As US productivity cannot rise as fast as the current wage growth of 4.5-5.5% (Chart 4), the ratio of wages to productivity (unit labor costs) is escalating. Unit labor costs are rising faster than they have in the past 38-40 years. Historically, an acceleration in unit labor costs has often heralded higher inflation (Chart 5). Chart 3US Wages Will Continue Accelerating US Wages Will Continue Accelerating US Wages Will Continue Accelerating Chart 4Wage Growth Is Outpacing Productivity Gains Wage Growth Is Outpacing Productivity Gains Wage Growth Is Outpacing Productivity Gains   Chart 5Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation The only period when US core inflation fell despite rising unit labor costs was during the second half of the 1990s (Chart 5). During this period, EM currency devaluations from China to Mexico and then to Asia unleashed the deflation tsunami in goods prices. US imports prices from Asia collapsed allowing US inflation to drift lower despite rising unit labor costs. The current backdrop is different: US import prices from Asia, including China, are rising (Chart 6). Importantly, US wage growth is presently below headline and core CPI, i.e., real wages are contracting (Chart 7). Provided US employees have experienced a decline in their purchasing power in the past 12 months, they are keen to secure substantial pay raises in the coming months. Chart 6Unlike The Late 1990s, US Import Prices From Asia Are Rising Unlike The Late 1990s, US Import Prices From Asia Are Rising Unlike The Late 1990s, US Import Prices From Asia Are Rising Chart 7US Real Wages Are Shrinking US Real Wages Are Shrinking US Real Wages Are Shrinking   Employers facing strong demand cannot afford an employee exodus. Businesses will raise salaries and hike selling prices to preserve their profit margins, thereby giving rise to a wage-price spiral. Bottom Line: The ultimate inflation anchor is unit labor costs. This is why wages, more specifically unit labor costs, are the most important variable to monitor. If relative price shocks lead employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. The Fed’s Dilemma When inflation becomes pervasive and entrenched, as it is now in the US, the only way to bring it down is to slow the economy. Unless demand decelerates meaningfully, US inflation will not go away because it has already spilled over into consumer and business expectations. Even though US headline and core CPI will likely drop in the coming months, core inflation will remain well above the Fed’s target of 2% (Chart 1 above). To maintain its credibility, the Fed should hike rates continually despite the potential rollover in headline and core CPI measures. Chart 8High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months My colleague, Jonathan Laberge, Managing Editor of the Bank Credit Analyst, has quantitatively estimated that there is a almost 100% probability that in next 12 months core PCE inflation will be above 3%, and a 70% probability that it will be above 4% (Chart 8). All this means that if the Federal Reserve is serious about bringing core inflation closer to 2%, it will have to slow down the economy meaningfully. In short, the Fed cannot both achieve decent growth and bring inflation down to its 2% target in the next 1-2 years. The Fed seemed omnipotent over the past 35 years because inflation was falling or was very low. That allowed US monetary authorities during financial crises/deflationary shocks to cut rates aggressively and flood the system with liquidity. That playbook worked well in a disinflation context and the US central bank has prevented protracted debt deflation. When inflation – rather than deflation – is the problem, authorities can do little without slowing growth. In short, an inflation redux has made US policymakers’ jobs much more difficult. If the Fed tightens too much, the economy will slump. If policymakers drag their feet and do not raise interest rates rapidly and significantly, inflation will hover well above its target and inflation expectations will escalate with negative ramifications for the economy (more on this below). Bottom Line: The Fed is facing an acute dilemma. The Fed will not publicly acknowledge it, but financial markets are gradually waking up to the new reality that the era of an omnipotent Fed might be over, at least for a period of time. Why Not Allow Inflation To Proliferate? Why should authorities tighten policy and slow growth to reduce inflation? Why can’t the US operate with inflation in a range of 3.5-5%? First, there is no guarantee that core inflation will stabilize at 3.5-5% and not rise further. When higher consumer and business inflation expectations set in, they are not easily dislodged. Second, persistent inflation can damage growth itself. High price volatility increases business uncertainty as producers cannot properly plan their costs and selling prices. Higher uncertainty leads companies to abandon expansion projects and new investments. Consequently, economic growth, employment and ultimately productivity suffer. Lower productivity growth creates fertile ground for inflation to thrive. This can lead to stagflation whereby growth slows but inflation remains high. Finally, from a political perspective, inflation can be more damaging to a government’s popularity than modestly high unemployment. For example, if the unemployment rate is at 6-7%, there would be some unhappy voters, but the majority of the population would be employed and their real purchasing power would be rising. Hence, the majority of voters might be content about the incumbent government’s policies.  In an inflation scenario, however, everyone would be unhappy because inflation erodes the purchasing power of household income and wealth. The point is that moderately high unemployment affects a few families who do not have jobs while inflation affects everyone. US politicians and policymakers have forgotten the perils of inflation because rapidly rising prices have not been a problem for decades. Therefore, they have erred on the side of helicopter money assuming that deflationary pressures and higher unemployment are worse than inflation. They have forgotten that inflation is not only worse for the wider population but that it could cause growth to slump resulting in stagflation: a combination of high inflation and high unemployment. Inflation has already become a political problem in the US. With income growth lagging behind inflation, household purchasing power has declined, which has fueled dissatisfaction with the current government. Biden’s popularity has tanked in the past nine months along with the rise of inflation. If inflation is not quelled by this fall, chances are that the Democrats will lose Congress to the Republicans in the midterm elections. Further, if high inflation persists in the next two years, odds of a Republican candidate winning the 2024 presidential elections will be considerable. Recognizing this, the Biden administration will not oppose the Fed’s hawkish policy for now. While we are sympathetic to the view that the Fed will ultimately not raise rates too aggressively, they have no reason not to hike and cannot afford to appear dovish at the current juncture. Even as headline and core inflation measures start falling (which is very likely in the months ahead), the Fed has no excuse to turn dovish. The rationale is that the US core inflation rate, while dropping from 5.5-6%, will still be well above the central bank’s target of 2%. In our opinion, the Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from current levels. Bottom Line: Until panic selling occurs in the equity and credit markets or the economy is materially weaker, the Fed will hike interest rates at every meeting and will start quantitative tightening soon. Thus, US bond yields and the US dollar have more upside for the time being. Overall, the Fed and equity markets are on a collision course: the Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Implications For Financial Markets Chart 9Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated As long as the Fed maintains its hawkish bias (which is very likely in the coming months), US bond yields will rise and/or the yield curve will flatten, the greenback will be firm, and stocks will struggle. The current environment will be more reminiscent of what occurred in the late 1960s than any other period of the past 40 years. In the second half of the 1960s, when US core CPI spiked, US share prices became negatively correlated with US bond yields (Chart 9). We discussed this topic at great length in a report from a year ago. Hawkish monetary policy amid the inflation overshoot means that the Fed appears to be credible, and this stance is positive for the US dollar. As soon as the Fed makes a dovish pivot however, the US dollar will tank. The basis is that by turning dovish earlier than warranted, odds are that inflation would remain well above its target, i.e., the Fed would fall behind the inflation curve. When a central bank is behind the inflation curve, the currency depreciates. Our US Equity Capitulation Indicator has fallen quite a bit but has not yet reached its 2018, 2016, 2011 and 2010 lows (Chart 10). We believe the macro backdrop is poor enough to justify a pullback on par with those selloffs (17-20% from the peak). In such an environment, EM stocks will outperform DM only if the US dollar weakens (Chart 11). Chart 10More Downside In The S&P 500? More Downside in The S&P 500? More Downside in The S&P 500? Chart 11EM Relative Equity Performance Moves With The US Dollar EM Relative Equity Performance Moves With The US Dollar EM Relative Equity Performance Moves With The US Dollar ​​ Chart 12Will The Current Episode Play Out Like Q4 2018? Will The Current Episode Play Out Like Q4 2018? Will The Current Episode Play Out Like Q4 2018? Alternatively, we might be witnessing a replay of Q4 2018 when the S&P 500 sold off hard led by tech stocks, but having underperformed earlier that year EM outperformed (Chart 12). While such a scenario is quite possible, we need to downgrade our view on the US dollar in order to upgrade EM stocks from underweight. We are not ready to do so because we believe the Fed’s hawkish bias will for now support the greenback. On the whole, we continue to recommend underweight allocations to EM equities and credit markets within their respective global portfolios. Absolute-return investors should stay cautious on EM risk assets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Please note this is the view of Emerging Markets Strategy team and does not reflect the view of other BCA services.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Executive Summary Foreign And Domestic Politics Won't Stop The Fed Foreign And Domestic Politics Won't Stop The Fed Foreign And Domestic Politics Won't Stop The Fed Investors woke up to the Ukraine risk this week. It is not yet resolved. Stay defensive. Market reactions to Ukraine suggest investors will favor defensive sectors and growth stocks in the short term, with the notable exception of the energy sector. External risks will not dissuade the Fed from hiking rates in the face of 6% core inflation. Later the Fed might adjust to foreign crises but the stock market faces more downside in the interim. Polarization is reviving ahead of the midterm elections, which will usher in gridlock. Gridlock is disinflationary, reinforcing a tactically defensive market positioning despite our cyclical House View. Bottom Line: Biden’s external risks are not yet subsiding. The Fed will hike rates even in the face of external supply shocks. Stay tactically defensive. Feature Our three key views for the year are: gridlock, executive power, and foreign policy. First, Congress will become gridlocked even prior to the midterm elections. Second, President Biden will have to shift to executive power to achieve policy objectives. Third, Biden’s focus will be forced to engage in foreign policy more than he would prefer due to rising external risks. The Ukraine crisis – covered extensively in our Geopolitical Strategy – is the most pressing external risk but it is not the only one that we think will trouble markets this year. We expect politically induced volatility to persist all year. The cyclical investment view should be driven by the underlying macroeconomic reality. But that macro reality will change if external risks materialize and cause greater supply disruptions or if they alter the US midterm election outlook. We maintain our tactically defensive positioning for now. Mr. Market Wakes Up To Ukraine Risk The reason for the crisis is the historic Russian military buildup on all sides of Ukraine, in the face of US defense cooperation with Ukraine, not the “hysterical” American propaganda over the risk of war. When and if Russian forces withdraw, the crisis will melt away. But for now, Russia’s reported withdrawal of some troops is contradicted by movements of other troops as well as the fact that the Russian navy has effectively blocked off the Black Sea. Investors must judge by capabilities, not intentions, and Russia still has the capability to stage a limited attack at present so investors should maintain a defensive or cautious approach. In this context investors are rightly bidding up the US dollar and bidding down US equities in absolute terms (albeit not relative to European equities). Bond yields have not responded much to the external risk due to the high rate of inflation, which is pushing yields up (Chart 1). If Russia re-invades, stocks and bond yields will fall at least temporarily and the dollar will rise higher. When Russia initially invaded Ukraine eight years ago, in February 2014, the US stock-to-bond ratio moved sideways for several months but cyclicals outperformed defensives. Energy stocks rallied, until the oil crash in summer 2014. Small caps underperformed large caps, yet value outperformed growth stocks (Chart 2). Small caps likely suffered from risk-off sentiment and expectations of a drag on global growth, while value benefited from gently rising interest rates at that time. Chart 1Ukraine Crisis Escalates Ukraine Crisis Escalates Ukraine Crisis Escalates Chart 2Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 Comparing the situation today, the difference is that cyclicals are trailing defensives and small caps are trailing large caps even more than they were in 2014. Yet value stocks have performed far better against growth now than then, in accordance with higher inflation and bond yields (Chart 3). Further escalation of the Ukraine crisis should drive investors to favor defensives, large caps, and growth stocks on a tactical time frame, even though this decision runs against our BCA House View on a cyclical time frame. The past week’s market moves reinforce the 2014 experience in general, with the stock-to-bond ratio faltering and cyclicals falling back (Chart 4). Small caps and value have benefited but these charts suggest that a negative hit to global growth will hurt small caps, while value is overextended relative to growth in the short term. The market only really began to discount the risk of a new war in Europe this past week, specifically on Friday, February 11 and Monday, February 14. Chart 3Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Chart 4US Equities Just Woke Up To Ukraine US Equities Just Woke Up To Ukraine US Equities Just Woke Up To Ukraine There is not yet a solid diplomatic solution as we go to press on Tuesday, February 15, but some positive signs are fueling a rebound in risk assets. Fade these improvements in risk appetite until Russia makes its decision on whether to use military force and, if so, until Europe makes its decision on whether to impose crippling sanctions.  Bottom Line: Tactically stay long growth stocks versus value, but prepare to switch back to overweighting value if the Ukraine crisis abates. The Energy Sector Response To Ukraine So Far Commodity prices and the energy sector are naturally benefitting from rising supply risks. But there is a risk that they will suffer later if a war breaks out and generates a supply shock and energy price shock that weigh on European and global growth. Russia will likely maintain energy production to help pay for its military adventures. The Saudis could increase production to prevent demand destruction. It is also possible that a US-Iran nuclear deal could release Iranian oil to the market. The global economy can handle gradually rising energy prices but maybe not a sharp supply shock. Oil prices are rising on signs of escalating tensions and energy sector equities are generally outperforming the broad market and other cyclical sectors. Domestically oriented small cap energy stocks are rising relative to large caps, suggesting that the market does not believe that global growth will suffer greatly from any conflict. Apparently investors do believe that US energy companies will benefit from shipping more fossil fuels abroad (Chart 5). Bottom Line: Cyclically stay long small cap energy stocks versus their large cap brethren. Chart 5US Energy Sector Just Woke Up To Ukraine US Energy Sector Just Woke Up To Ukraine US Energy Sector Just Woke Up To Ukraine Peak-To-Trough Drawdowns Amid Geopolitical Crises The peak-to-trough equity drawdown amid major geopolitical crises ranges from 11%-15%, depending on the magnitude and nature of the crisis (Chart 6). In this case, the US will not be directly involved in any war in Ukraine, but US NATO allies will be right next door and providing aid to Ukraine. For “limited incursion” scenarios we looked at over a dozen crises, from the Berlin Blockade of 1949 to the Russian invasion of Crimea in 2014. The peak-to-trough drawdown averages 10%. For an unlimited or “full-scale” invasion, we looked at the S&P500 reaction to major invasions at the dawn of World War II as well as significant wars in the twentieth century, down to the US invasion of Iraq and NATO’s intervention in Libya in 2011. The peak-to-trough equity drawdown averaged 13%. Chart 6Range Of US Equity Peak-To-Trough Drawdowns Amid Geopolitical Crisis Biden, The Fed, And External Risks Biden, The Fed, And External Risks Given that the S&P500 has fallen by 8% since its peak on January 3, 2022, investors should be prepared for more downside. Health care stocks and consumer staples are outperforming the broad market this year so far, though they are underperforming energy where the supply squeeze is happening (Chart 7). The magnitude of war and sanctions will determine whether energy ultimately falls in expectation of demand destruction. Bottom Line: It is too soon to buy the dip in the S&P 500. Stay long health stocks relative to the broad market. Chart 7Health Care And Consumer Staples Health Care And Consumer Staples Health Care And Consumer Staples Will The Fed Respond To External Risks? No. Over the past year, we have argued with investors who tried to differentiate the current bout of inflation from the inflation of the 1970s by arguing that there is no energy supply shock. We argued that an energy shock could transpire by pointing to external risks such as Russia and Iran. While the Biden administration will likely prove risk-averse, for fear that higher prices at the pump will weigh on the Democratic Party in the midterm elections, what about the Federal Reserve? During the Arab oil embargo of late 1973, and the Iranian revolution of 1979, the Federal Reserve continued to hike interest rates, responding to domestic inflation and rising bond yields. Foreign supply shocks threatened to push up inflation, so the Fed was not deterred from hiking rates (Chart 8). When the US itself engages in war, the Fed might react differently (Chart 9). Chart 8The Fed Responds to Oil Shocks by Hiking Rates But... The Fed Responds to Oil Shocks by Hiking Rates But... The Fed Responds to Oil Shocks by Hiking Rates But... Chart 9... US At War Could Trigger Looser Monetary Policy ... US At War Could Trigger Looser Monetary Policy ... US At War Could Trigger Looser Monetary Policy In 1990, the Fed cut the policy rate once after the US entered the Iraq war, then kept rates flat for a few months before cutting more at the end of the year. Bond yields were falling due to recession. In 2001, the Fed was already cutting rates due to the business cycle and the September 11 terrorist attacks reinforced that process. In 2003, the Fed cut rates after the beginning of the Iraq war and did not start hiking rates until mid-2004 when the initial phase of the war ended. The implication is that Fed Chair Alan Greenspan accommodated both the war and the 2004 presidential election. Most external risks will not prevent the Fed from hiking rates, especially during an inflation bout when the nature of the external risk may be an energy supply disruption that pushes up prices. However, while we do not doubt that the Fed could hike by 50bps in March, we doubt that the consensus of 175bps in hikes in 2022 will pan out. The combination of initial hikes, fiscal drag, and foreign growth shocks would temper the Fed’s enthusiasm. Bottom Line: Stocks face more downside risk in this environment.   Bipartisanship And The Return Of Gridlock Polarization and partisanship are recovering. The Philadelphia Fed “Partisan Conflict Index” is now only 0.6% below its 2020 peaks as the midterm election approaches (Chart 10). Interestingly, one of our key views from last year – bipartisan reform – is still taking place beneath the surface. Our 2022 view of gridlock has not yet fully set in. Congress is stealthily cooperating on fiscal spending, the US Postal Service, women’s issues, public servants’ stock trading, and an attempt to revise the Electoral Count Act. Congress is also passing a bipartisan bill to make the US more economically competitive with China and impose sanctions against Russia. Chart 10Foreign And Domestic Politics Won't Stop The Fed Foreign And Domestic Politics Won't Stop The Fed Foreign And Domestic Politics Won't Stop The Fed The only area where bipartisanship is not happening is Biden’s “Build Back Better” reconciliation bill, which even lacks sufficient support from moderate Democratic senators due to high inflation. Passage is still possible in a partisan, watered-down, and deficit-neutral form. These developments show that Republican lawmakers are demonstrating some pragmatic governing ability and will use their voting records to make a case in the midterms, while pinning the blame for inflation, crime, immigration, and any foreign crises on Democrats. As such they reinforce the market consensus that Republicans are likely to take back Congress this fall. Thus while last year’s bipartisanship is spilling into the current legislative session, gridlock is rapidly approaching. When investors look to the second half of the year and beyond, they should expect to see legislative cooperation dry up, especially if Republicans only take the House and not the Senate. Bottom Line: Gridlock will freeze fiscal policy, which is non-inflationary or disinflationary for 2022-24. As such the midterm election is not fully priced. Midterm dynamics will support an overweight or at least neutral stance toward defensives and growth stocks. Investment Takeaways Tactically stay long defensives, notably health care, and growth stocks. Cyclically remain invested in the bull market – and stay long energy small caps. The chief risks to these views would be a speedy diplomatic resolution to the Ukraine and Iran conflicts or a dramatic revival of the Democratic Party’s popular support ahead of the midterm election. Diplomacy would remove risks to global growth, whereas a Democratic comeback would boost inflation expectations.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden, The Fed, And External Risks Biden, The Fed, And External Risks Table A3US Political Capital Index Biden, The Fed, And External Risks Biden, The Fed, And External Risks Chart A1Presidential Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Chart A2Senate Election Model Biden’s Floor, Republican Cracks Biden’s Floor, Republican Cracks Table A4APolitical Capital: White House And Congress Biden, The Fed, And External Risks Biden, The Fed, And External Risks Table A4BPolitical Capital: Household And Business Sentiment Biden, The Fed, And External Risks Biden, The Fed, And External Risks Table A4CPolitical Capital: The Economy And Markets Biden, The Fed, And External Risks Biden, The Fed, And External Risks Footnotes  

Executive Summary China 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 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China 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 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations