Fixed Income

Highlights There are a few consistencies with the dollar breakout. Global growth is peaking and the risk of a significant slowdown early next year has risen. As a momentum currency, further gains in the DXY remain very high in the near term. We are shifting our near-term target to 98 (previously 95). That said, the dollar is now close to pricing a global recession, which seems improbable given easy monetary settings and ample fiscal stimulus. High inflation is not a US-centric phenomenon but a global problem. This means that monetary policy in the US cannot sustainably diverge from other central banks. Correspondingly, low US TIPS yields do not confirm the breakout in the dollar. Even if the US 10-year Treasury yield rises towards 2.5%, real interest rates will remain very low compared to history and other G10 economies. While global growth will slow next year, we expect that it will remain robust. And if it rotates from the US to other countries, the dollar will have a very sharp reversal. Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Feature Chart I-1The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates After spending most of this year range bound between 89 and 94, the DXY index has broken out. The narrative has been centered around rising US inflation, which will trigger much faster interest rate increases from the Fed. This is consistent with recent economic data, where US inflation has indeed blown out, and is also rising at the fastest pace among G10 countries. What has been inconsistent is that US TIPS yields remain very low, and have diverged from the broad dollar trend (Chart I-1). One of the key structural drivers of currencies is real interest rate differentials. If the Fed does move ahead of the inflation curve and aggressively hikes interest rates, then US TIPS yields will rise and catch up with the dollar. Otherwise, the recent rise in the greenback could represent a capitulation phase that will quickly reverse should the inflationary mania subside. Consistencies With The Dollar Rise The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year (Chart I-2). Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent). The market suggests that compared to earlier this year, a 63bps spread difference is now warranted between US and European interest rates, while an 80bps difference is appropriate vis-à-vis Japanese rates. This shift perfectly explains the move in the dollar over the last few weeks (Chart I-3). Chart I-2Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Chart I-3A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally These market moves have been consistent with economic developments. Upside economic surprises in the US have dominated other G10 economies and supported the dollar (Chart I-4). The slowdown in China has been another hiccup in the global growth story. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is metastasizing into a genuine slump that will impact commodity import demand and hurt procyclical currencies liked the AUD (Chart I-5). Chart I-4Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Chart I-5A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD The slowdown is not unique to China. With new Covid-19 infections surging in various European countries, ex-US economic data is likely to remain underwhelming early next year. Within this context, the US economy remains relatively immune. Exports explain only 10% of US GDP. The IMF projects that the US is one of the first countries to close its output gap (Chart I-6). This will support a tighter monetary stance in the US, compared to other G10 countries. Chart I-6 Contradictions With The Dollar Rally There are a few contradictions with the dollar rally. First, the Fed is already lagging the US inflation curve. Various DM and EM central banks have calibrated monetary policy higher in response to rising inflation (Chart I-7). While the Fed might accelerate the pace of tapering asset purchases, other central banks in developed economies have already ended QE and are raising rates. At some point, relative monetary policies would matter for currencies, as has historically been the case. Since the start of the year, market pricing for higher rates according to the OIS curve has been lifted for most G10 countries (Table 1). Yet the dollar has rallied, while other currencies have collapsed (Chart I-8). Chart I-7Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Chart I- Chart I-8Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Second, part of that rally has been driven by speculative inflows, and not by underlying economic fundamentals. Net speculative positions in the US dollar are near levels that have usually signaled that the trade is becoming much crowded (Chart I-9). As we highlighted in Chart 1, this has occurred amidst very low nominal and real interest rates. But more importantly, as a reserve currency, the dollar enjoys the priviledge of being the safe-haven asset of choice. It is quite plausible that one of the key drivers of the rally has also been hedging by fund managers for an equity market correction (Chart I-10). Chart I-9Speculators Are Nearing Exhaustion ##br##Levels Speculators Are Nearing Exhaustion Levels Speculators Are Nearing Exhaustion Levels Chart I-10Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Third, inflation could indeed prove to be transitory. Our sister publication, the Commodity & Energy Strategy, suggests that metals and oil prices will remain well bid in the near term. Inflation however is about rates of change. Natural gas prices rose 100% this year while oil prices rose 60%. Market expectations are that these prices will roll over (Chart I-11). The Baltic Dry Index, a proxy for shipping costs and supply bottlenecks, initially rose 300% and is now down 53% from its peak. A middle ground where prices remain well bid but do not generate the same inflationary impulse next year seems most plausible. This will ease all market expectations for central bank hawkishness, but could sound the death knell for the dollar that has quickly moved to price in the current market narrative. Chart I-11Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Fourth, a strong US dollar hurts US growth. According to the Fed’s own estimates, a 10% rise in the dollar reduces US growth by 0.5% in the subsequent four quarters and 1.2% over two years. Meanwhile, a strong US dollar will certainly alleviate pressure on the Fed to fight inflation. A Counterpoint View To The Market Narrative Covid-19 will be with us for a while. As such, the volatility of growth forecasts around infection waves will subside. The remarkable thing is that despite fears of a global growth slowdown, there is a pretty robust expectation that the US will fare poorly relative to other developed markets in terms of growth next year. Countries such as Canada, New Zealand, the UK, and Japan are seeing a bottoming in growth momentum relative to the US (Chart I-12). For some, this is occurring at the same time as their local central banks are becoming more orthodox about monetary policy. As we have argued earlier, this is clear real-time evidence that the Fed will lag the inflation curve. Chart I-12AA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US Chart I-12BA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US One key signpost is China. It has tightened policy amidst very low inflation, and the traditional relationship between real rates and the RMB is working like a charm as the currency appreciates in trade-weighted terms. In a nutshell, currency markets tend to reconverge with real interest rate differentials over time. This will eventually be the case with the dollar (Chart I-13). Chart I-13Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Finally, China might marginally ease policy to sustain growth. In our view, China could stand pat since nominal bond yields are falling and exports are robust suggesting overall financing conditions are not a problem. But if this is a primate cause for fuelling long dollar bets, that will eventually hurt EM demand, China could also shift. This will be bullish for the dollar in the near term (it will require a riot point for China to shift), but bearish the dollar over a cyclical investment horizon, as commodity economies bottom. Investment Strategy Chart I-14Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession In the current environment, the DXY could hit 98. This will be consistent with a blowout in our capitulation index, as well an exhaustion of dollar bulls. That said, the dollar is now close to pricing a global manufacturing recession, which seems improbable given easy monetary settings and ample fiscal stimulus in most DM economies (Chart I-14). Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Finally, our agnostic trading model continues to suggest short dollar positions (Chart I-15). Admittedly, it is the valuation component driving the calibration, rather than sentiment or appreciation for the investment shift in the macro narrative. In our portfolio, we will sit on the sidelines until most of our intermediate-term indicators stage a reversal. Chart I-15AOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Chart I-15BOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed A Setback For The Fed A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations 2022 Rate Expectations 2022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Short-term Inflation Expectations Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Long-term Inflation Expectations Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record The Fed’s Inflation Problem The Fed’s Inflation Problem Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Goods Inflation Goods Inflation Chart 8Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Peak Shipping Costs Peak Shipping Costs Chart 10The Upside In Real Yields The Upside In Real Yields The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Gross Leverage Is Falling Gross Leverage Is Falling Chart 12Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Leverage Ratios Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) Chart 7 We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate House Price Appreciation Could Moderate House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD Chart 16 In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2   Chart I-7The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, The next two BCA Research Global Fixed Income Strategy reports will be jointly published with other BCA services, which will impact the publishing dates. Our next report will be a joint Special Report on Australia, published with our colleagues at Foreign Exchange Strategy, which you will receive this Friday, November 19. The following report will be a joint Special Report published with European Investment Strategy, which you will receive on November 29. -Rob Robis   Highlights High realized inflation rates are pushing up longer-term inflation expectations toward all-time highs, while also weighing on consumer confidence, in the US and the UK. The inflation overshoot has not been as severe in the euro area, but consumer confidence appears to be rolling over there too. Over the next year, central banks will have to manage around the communications challenges posed by a rise in inflation that is perceived to be more supply-driven than demand-driven and, hence, beyond the full control of monetary policy. Public opinion surveys are showing eroding satisfaction with the Fed and Bank of England, while similar surveys in the euro area show public trust in the ECB remains strong despite higher euro area inflation.  We continue to favor overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23, compared to the euro area, in order to restore central bank credibility.  Feature Rapidly accelerating inflation has become front-page news around the world. It is also increasingly becoming a political issue and not just an economic one. After the release of the October US consumer price index (CPI) report, where headline inflation came in at a 30-year high of 6.2%, US President Joe Biden had to issue a formal White House statement acknowledging that inflation “hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” Biden also pulled off the neat trick of both committing to, and subtly challenging, the Fed’s independence when he noted that “I want to reemphasize my commitment to the independence of the Federal Reserve to monitor inflation, and take necessary steps to combat it.” The Great Inflation Of 2021 (and 2022?) has raised a new risk for both politicians and investors. As long as the high inflation persists, and for as long as central banks seem unwilling or unable to respond to try and bring down inflation with tighter monetary policy, consumer confidence will be negatively impacted – even if job growth remains reasonably healthy. Confidence & Inflation: A Matter Of Trust Chart of the WeekHigh Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence High Inflation Weighing On Consumer Confidence The preliminary read on US consumer confidence for November from the University of Michigan survey showed sentiment hitting a ten-year low, largely on worries about the impact of rising inflation on household spending power. This effect of high inflation eroding consumer confidence is not just a US phenomenon (Chart of the Week). UK consumer sentiment is also falling due to what has been described as “a potential cost of living crisis” by consumer research firm GfK. In the euro area, however, consumer sentiment is still relatively elevated, but is starting to roll over as headline inflation reaches a 13-year high of 4.1% in October. From the point of view of financial markets,  surging inflation is still expected to be a short-lived phenomenon, although conviction on that view is starting to wane. Market-based inflation expectations curves for the US, UK and euro area are all currently inverted, with shorter-maturity expectations above longer-maturity ones (Chart 2). Yet the upward momentum of those measures across all maturity points is showing little sign of ebbing, especially in the US. The 2-year TIPS breakeven rate now sits at a 16-year high of 3.51%, the 5-year breakeven is at an all-time high of 3.22%, while the 10-year breakeven of 2.77% is now just a single basis point below its all-time high reached in 2005. The story is similar in the UK, where RPI swap rates for the 2-year, 5-year and 10-year maturities are 5.3%, 4.8% and 4.3%, respectively – all hovering near all-time highs (as are breakevens on index-linked Gilts). Euro area inflation expectations are not so historically elevated, and the inflation curve is not as inverted, but the 2-year euro CPI swap rate is still at a 15-year high of 2.4% compared to a 9-year high of 2.0% - right at the ECB’s inflation target - for the 10-year CPI swap rate. In the US, the survey-based measures of inflation expectations are telling a similar story. The New York Fed’s Consumer Survey shows that median 3-year expectations are now at 4.2% with 1-year expectations even higher at 5.7% (Chart 3). Meanwhile, the early November read on inflation expectations from the University of Michigan survey showed that 1-year-ahead expectations climbed to a 13-year high of 4.9%, while the longer-term 5-10 year inflation expectations were unchanged from the October reading of 2.9%. Chart 2Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Rising Inflation Expectations, Both Short- & Long-Term Chart 3A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation A Broad-Based Surge In US Inflation The latter figure may provide some comfort to the Fed, with surging shorter-term expectations not fully leaking through into longer-term expectations. However, the longer the inflation upturn persists, the more likely it will be that US consumers begin to factor in a higher rate of longer-term inflation, just as TIPS traders are doing. After all, the Michigan 5-10 year measure has still climbed by 0.7 percentage points from the pre-COVID low. Even more worrying from the Fed’s perspective is that inflation expectations are rising for essentially all Americans. The New York Fed Consumer Survey shows that 3-year-ahead inflation expectations are rising across all levels of education (Chart 4) and income cohorts (Chart 5). Chart 4US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... US Inflation Expectations Are Rising For All Education Levels... Chart 5...And Income Levels ...And Income Levels ...And Income Levels The New York Fed also compiles a measure of consumer inflation uncertainty (bottom panels of both charts on page 5). Survey participants are asked to provide probabilities of inflation falling within certain ranges, with the gap between the top and bottom quartiles of those expected inflation outcomes representing the “uncertainty” over future US inflation. Perhaps unsurprisingly, the dispersion of inflation forecasts is typically much wider for those earning lower incomes and with less education. Yet even highly educated, high earning Americans are reporting wider gaps in possible inflation outcomes, in sharp contrast to the pre-COVID years where their expectations were low and stable. Americans Are Having Second Thoughts About The Fed Any way you cut it – TIPS breakevens or survey-based measures - US inflation uncertainty and volatility have increased. This appears to be starting to erode public confidence with the Fed. Along with its consumer confidence surveys, the University of Michigan also publishes a periodic survey of Confidence In Financial Institutions like commercial banks, asset managers and, most importantly, the Fed. The last survey was just conducted for the September/October 2021 period and showed that 43% of respondents reported a loss of confidence in the Fed compared to five years ago (Chart 6). That is up from 36% reporting a loss of confidence in the last such survey conducted in 2019, and is approaching the +50% levels seen in 2008 (the Financial Crisis) and in 2011 (the Taper Tantrum) – episodes where the Fed had difficulty maintaining economic and financial stability. Chart 6 The University of Michigan also noted that reported consumer confidence was much lower for those claiming to have less confidence in the Fed, and vice versa (Chart 7). Chart 7 Taken at face value, this survey shows that the Great Inflation of 2021 has shaken the public’s faith in the Fed’s ability to maintain economic stability. Combined with the message from the New York Fed Consumer Survey on the growing instability of American inflation expectations, this shows that the Fed may be facing an uphill climb to restore some of the credibility it has lost this year. Much like all aspects of American life these days, political partisanship must be factored in the analysis of US confidence data. The regular monthly University of Michigan sentiment survey for November noted that various measures of US confidence were consistently higher for respondents who reported to be Democrats compared to Republicans since President Biden took office (Chart 8). This is a mirror image of the years under President Trump (pre-pandemic), where Republicans consistently reported greater optimism than Democrats. Chart 8 Chart 9Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad Americans Can Agree On One Thing - High Inflation Is Bad The University of Michigan Confidence in Financial Institutions survey also noted that less trust in the Fed was reported more frequently by Republicans (67%) than Democrats (27%) in 2021, the first year under Biden. This compares to 2017, the first year of the Trump Administration, where more Democrats (41%) reported less trust with the Fed compared to Republicans (30%). The Michigan survey described this “partisan identification” as being a “significant correlate of consumer assessments of the Federal Reserve, treating the Fed as part of the administration rather than an independent body.” Consumer confidence among reported Democrats has been falling since April of this year, although there is still room to catch up to the complete collapse of sentiment seen among Republican consumers (Chart 9, top panel). High US inflation is hitting everyone hard. The surge in inflation expectations is overwhelming income expectations for the next year, according to the New York Fed Consumer Survey (middle panel). High realized inflation has also eroded real spending power, with real average hourly earnings having contracted in year-over-year terms since April of this year (bottom panel). Even with that fall in real income growth perceptions, the plunge in the University of Michigan US consumer confidence has not been matched by other measures like the Conference Board US consumer confidence index, which remains well above pandemic era lows. Even more importantly, US consumer spending has held up well, with nominal retail sales expanding by +1.7% in October following a +0.8% gain in September. Some of those increases were due to rising prices, but were still significantly above inflation in both months, suggesting a solid pace of real consumer spending (the headline US CPI index rose +0.9% and +0.4% in October and September, respectively). For the Fed, the case is building to begin preparing Americans for higher interest rates in 2022. This is true both from an economic perspective – the US economy is likely to continue growing above trend next year, further tightening the US labor market – and in response to the high inflation that has caused some damage to the Fed’s credibility. What About The UK And Euro Area? Looking across the Atlantic, survey-based measures of inflation expectations have also climbed steadily higher (Chart 10). The YouGov/Citigroup survey of UK consumer inflation expectations is now at 4.4% for the 1-year-ahead measure and 3.7% for the longer-run 5-10 year ahead measure, both well above the BoE’s 2% inflation target. The European Commission surveys show a rapidly rising share of European Union businesses and consumers expect higher prices in the coming months. Yet while inflation expectations are rising in both the UK and Europe, only the UK shows the sort of deterioration in central bank confidence that is evident in the US. 48% of Europeans expressed confidence in the ECB, according to the Eurobarometer public opinion surveys – the highest share since 2007 and well above the 36% level seen after the Global Financial Crisis and European Debt Crisis (Chart 11). Some of that improvement in perceptions of the ECB mirrors better sentiment over the euro currency itself, as evidenced by that fact that both Germans and Italians now express similar levels of ECB confidence. Chart 10High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US High Inflation Is Also A Problem Outside The US Chart 11Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB Europeans Have Not Lost Confidence In The ECB High levels of public trust in the ECB play an important role in anchoring European inflation expectations. The ECB introduced its own Consumer Expectations Survey as a pilot project last year, and the latest reading from October 2021 shows that 1-year-ahead inflation expectations are now at 3% and 3-year-ahead expectations are at 2%. Both measures were at 2% a year earlier, and have generally stayed close to ECB’s 2% inflation target since the survey began. Chart 12High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE High Inflation Is Worsening Public Satisfaction With The BoE A recent research report from the Bank of Finland concluded that European consumers who have high trust in the ECB adjust their medium-term inflation expectations more slowly than those with low trust. The high public confidence in the ECB seen in the Eurobarometer surveys, combined with the stability of medium-term inflation expectations (both survey-based and market-based) around the ECB’s 2% target – even with realized euro area inflation now at 3.4% - fits with the conclusions of that report. We read this as a sign that the ECB is not under the same growing pressure to tighten policy in the face of rising inflation as the Fed, which is facing an erosion of public confidence that is showing up in steadily rising inflation expectations. In the UK, the Bank of England (BoE) is facing a situation more akin to that of the Fed. The BoE’s Inflation Attitudes Survey has been showing a steady erosion of UK consumers reporting satisfaction with how the BoE has been setting policy to fight inflation (Chart 12). The “net satisfied” index fell to +18% in the last survey published in September – similarly low levels of BoE satisfaction coincided with major spikes in longer-term UK inflation expectations in 2008 and 2011 (bottom panel). Our conclusion from the UK consumer surveys, along with measures of inflation expectations that are well above the BoE medium-term target, is similar to that in the US. The UK public is losing faith in the BoE’s ability, or willingness, to tackle the high inflation “problem” – even if much of the inflation is caused by high energy prices and global supply chain disruptions that are beyond the immediate control of monetary policy. The BoE will likely need to follow through on the rate hikes markets expect in 2022 to help restore public trust and credibility, even if realized inflation slows from current elevated levels. This is especially true after the debacle of the November 4 BoE meeting where a widely-signaled rate hike did not occur. If the BoE continues to delay the start of tightening while inflation expectations are accelerating, this will only put more pressure on the central bank to tighten faster, and by more than expected, in a bid to stabilize inflation expectations. Investment Conclusions Chart 13Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Favor European Government Bonds Over US & UK Equivalents Our read of the various surveys shows that public trust in central banks has deteriorated in the US and UK, but not in Europe, because of surging inflation in 2021. This compounds the existing trends of tightening labor markets and accelerating wage growth in the US and UK that are more traditional reasons to tighten monetary policy. We continue to favor strategic overweights in euro area government bonds (both core and periphery) versus US Treasuries and UK Gilts, given the far greater likelihood of multiple rate hikes in the UK and US in 2022/23 in order to restore public trust in the Fed and BoE (Chart 13). The ECB can continue to be patient on responding to higher euro area inflation, given more stable euro area inflation expectations and with limited evidence that higher realized inflation is boosting European wage growth. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (November 16 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET and November 17 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights Despite strong economic activity throughout most of 2021, economic surprises have decreased considerably. This helped the US equity market outperform Europe. It also significantly contributed to the euro’s depreciation versus the dollar. Even though growth will slow in 2022, economic surprises should increase. Growth expectations are much lower than they were entering 2021, and some key headwinds will fade. This picture is not without risks. China’s credit slowdown and the US’s elevated inflation represent the greatest threats. Based on the outlook for economic surprises, the euro will stage a rebound next year and small-cap stocks are attractive. Feature Global economic activity has been exceptionally robust this year, boosted by the re-opening of the world economy, as well as by the considerable fiscal and monetary stimuli injected globally over the past 20 months. However, market participants also anticipated such a rebound; as a result, global economic surprises peaked in September 2020, and they are now in negative territory. Unanticipated developments have a substantial effect on market prices. Under this lens, the deterioration in economic surprises has had a strong impact on financial markets. It helps explain why the defensive US market has outperformed, why the dollar has been strong, and why bond yields have been flat since March 2021, even though inflation has risen, growth has been high by historical standards, and many major central banks have been eschewing their accommodative biases. Going forward, the evolution of economic surprises will remain crucial to market trends. While we anticipate global economic activity will decelerate in 2022, it will likely remain above trend and surprise to the upside, which will allow global economic surprises to recover. There are significant risks to this view, with large unanswered questions about the Chinese economy and the outlook for inflation in the US. In this context, despite near-term risks, we continue to expect EUR/USD to appreciate in 2022 and European small-cap stocks to outperform large-cap equities. Deteriorating Surprises Matter This year, the underperformance of global equities (both EM and Europe) relative to the US, the weakness in the euro, and the limited increase in yields have all caught investors off guard. At the beginning of 2021, investors were massively short the greenback and duration, while surveys showed a large preference for non-US equities. These views grew out of the expectation that global growth would be strong. Global growth turned out to be strong but began to disappoint expectations by the middle of the year. Expectations had become extremely lofty, suggesting that the bar had been set too high. Additionally, the tightening credit conditions in China and the growing supply constraints around the world caused growth to decelerate somewhat. The deterioration in short-term economic momentum and in surprises harmed European equities relative to the US. As Chart 1 highlights, the relative performance of European stocks is greatly affected by the earnings revision ratio of cyclicals stocks vis-à-vis defensive ones. This relationship reflects the greater pro-cyclicality of European equities compared to those of the US. Moreover, the earnings revision ratio of cyclical stocks relative to that of defensive equities mimics the fluctuations in economic surprises (Chart 1, bottom panel), as weaker-than-expected growth invites analysts to lower their relative earning expectations. The dynamics in the economic surprise index also weighed heavily on the FX market. The dollar is a highly counter-cyclical currency; therefore, it performs poorly when growth is not only increasing, but also doing so at a rate faster than anticipated. However, economic surprises did the exact opposite this year, which boosted the dollar’s appeal and pushed EUR/USD lower (Chart 2). While the strength in the dollar was accentuated by the increasingly aggressive pricing of Fed hikes in the OIS curve, relative interest rate expectations between the US and the Euro Area are also influenced by global economic activity because of the European economy’s greater cyclicality than that of the US. Chart 1Where Surprises Go, European Stocks Follow Where Surprises Go, European Stocks Follow Where Surprises Go, European Stocks Follow Chart 2Surprises Matter For The Dollar And The Euro Surprises Matter For The Dollar And The Euro Surprises Matter For The Dollar And The Euro Bottom Line: Global growth has been very strong in 2021, but it has begun to decelerate. Moreover, economic surprises are now in negative territory. The evolution of economic surprises this year was a key component of the strength in the dollar, the weakness of the euro, and the underperformance of European equities. Improving Surprises In 2022? We anticipate economic surprises to pick up in 2022. First, investors and analysts around the world rightfully expect a slowdown in global growth next year. This means that the bar for the economy to generate positive surprises is lower than it was in 2021. Second, we are already seeing signs that global economic surprises are trying to stabilize. A GDP-weighted aggregate of 48 countries is forming a trough at a low level, which historically precedes a pick-up in broader aggregate measures (Chart 3). Third, economic surprises move closely with the global PMI diffusion index. The diffusion index has fallen to levels historically associated with a rebound (Chart 4). Moreover, the share of countries whose Leading Economic Indicator is rising is still very depressed for a mid-cycle slowdown (Chart 4, bottom panel). As vaccination rates are improving around the world, including those in emerging markets, and as the global economy continues to re-open, we anticipate both the PMI and LEI diffusion indexes to improve next year, which will boost economic surprises. Chart 3A Budding Rebound? A Budding Rebound? A Budding Rebound? Chart 4The dispersion Of Growth Matters or Surprises The dispersion Of Growth Matters or Surprises The dispersion Of Growth Matters or Surprises Fourth, the global capex outlook remains very positive. Capex intentions in the US and in the Euro Area are highly elevated and cash flows are strengthening. Moreover, US and European credit standards are very loose (Chart 5). This combination suggests that companies have the desire and the wherewithal to increase their investments next year, especially as capacity constraints limit their ability to meet final demand. Additionally, companies around the world need to rebuild inventory levels, which are depressed relative to sales, while customer inventories are still woefully low (Chart 6). Chart 5Capex Tailwinds Capex Tailwinds Capex Tailwinds Chart 6Not Enough Inventories Not Enough Inventories Not Enough Inventories Chart 7Households Are Rich Households Are Rich Households Are Rich Fifth, households globally also have ample firepower to support their spending, despite some weakness in real income caused by rising inflation. As Chart 7 shows, household net worth in the US is up by 128% of GDP since December 2019. Additionally, the accumulated stocks of household excess savings have reached USD2.4 trillion in the US, EUR150 billion in German, EUR130 billion in France and GBP180 billion in the UK. With respect to the Eurozone specifically, fiscal and monetary policy will remain very accommodative. The fiscal thrust in 2022 will be negative 2.1%, which is significantly less onerous than the US’s -5.9% of GDP. Moreover, economies like Italy and Spain may have a negligible fiscal thrust because of the NGEU program’s disbursements. In addition, while the fiscal thrust will be slightly negative next year, government deficits will remain wide, which indicates that fiscal policy in Europe continues to support demand. Meanwhile, monetary policy still generates deeply negative interest rates on the continent, which sustains demand further. This view is not without risks. The first threat stems from the Chinese credit slowdown. BCA’s China strategists expect credit flows to bottom out by the second quarter of 2022, which implies that Chinese domestic activity should accelerate meaningfully in the second half of the year.  Already, we are seeing tentative signs that authorities in China are trying to curb the credit slowdown. For example, Beijing cut the reserve requirement ratio last summer and excess reserves in the banking system are moving back up as liquidity injections grow (Chart 8). The problem is that, so far, Chinese credit demand is not responding to these small measures designed to ease policy. More will be needed as the tightening in financial conditions for real estate developers points to significant downside ahead in construction activity (Chart 9). For now, it is difficult for Beijing to ease policy much more than it has done so far: PPI has reached a 25-year high at 13.5%. Chart 8Not Enough... Not Enough... Not Enough... Chart 9... Especially With Such A Drag ... Especially With Such A Drag ... Especially With Such A Drag These Chinese inflationary pressures are likely to decline in the first months of 2022, which will allow Beijing to become more aggressive in its support to economic activity. First, Chinese demand is weak, unlike demand in the US. Second, the surge in the PPI is mostly driven by a 17% increase in the energy PPI and a 66% surge in the mining component. These jumps are unlikely to repeat themselves, which will reduce overall inflationary numbers in that economy. The second major risk is global inflation, which is hurting real wages. As a case in point, US real wages are contracting at a 3.2% annual rate, or their deepest cut in six decades. In Europe too, real wages are weak because of the increase in inflation. While these inflationary pressures have had limited effect on European consumer confidence so far, US consumer confidence is breaking down (Chart 10), driven by a collapse in the willingness to buy. If this trend continues, we might see a significant deceleration in global real consumer spending. Chart 10Not All Is Dark On The Inflation Front Not All Is Dark On The Inflation Front Not All Is Dark On The Inflation Front We still expect the European inflationary risk to start dissipating in the first half of 2022. Unlike in the US, the spike in core CPI mostly reflects an increase in VAT and remains narrow, with trimmed-mean CPI lingering near record lows. Moreover, the 24-month rate of change of core CPI remains within the historical norm, which is not the case in the US. The US situation is more tenuous. Last week’s inflation data showed a broadening of inflationary pressures across major sectors of the economy unaffected by the pandemic, with shelter inflation being of particular concern. However, there are positives. Long-term inflation expectations, as approximated by the 5-year/5-year forward inflation breakeven rate, are still below the levels that prevailed before the oil price crash of 2014 (Chart 11, top panel). Additionally, shipping costs have started to ebb, with global container freight rates losing steam and the Baltic Dry index collapsing by 50% since beginning of October (Chart 11, bottom panel). Moreover, as health restrictions are being relaxed in Asia, Asian PMI’s are improving, while the production of semiconductors is rising again in the region (Chart 12). As a result, although there is still significant inflation risk over the next five years, 2022 is likely to witness a temporary pullback in CPI growth. Chart 11Not All Is Dark On The Inflation Front Not All Is Dark On The Inflation Front Not All Is Dark On The Inflation Front Chart 12Semiconductor Production Is Picking Up Semiconductor Production Is Picking Up Semiconductor Production Is Picking Up Bottom Line: Global investors are right to anticipate a decline in global growth next year. However, even if growth slows, it will remain above trend. Moreover, the considerable stimuli in the global economy and the decreased expectations of investors improve the odds that global economic surprises will increase in 2022. China’s domestic weakness and the rise in US inflation constitute the two greatest risks to this view. Investment Implications The level of the global economic surprise index as well as its evolution have important implications for many key European assets. Table 1 highlights the performance of various financial markets at three months, six months, and a year following various ranges of readings of the surprise index (the categories are based on one standard-deviation intervals from the mean). We highlight this methodology, because there remains significant uncertainty about the near-term outlook of the surprise index. Table 1Level Of Surprises And Subsequent Returns Surprise, Surprise Surprise, Surprise Currently, the global economic surprise index stands at -20, or between its -1-sigma and its historical average. This level offers limited clear results for investors when it comes to the performance of the Eurozone benchmark relative to the MSCI All Country World Index (ACWI), and no clear results in terms of the performance of value stocks relative to growth. However, the current reading of the surprise index is consistent with an outperformance of growth stocks relative to momentum over both the three- and six-month horizons. It is also showing a 74% probability of small-cap equities beating large-cap ones over a 12-month basis. Table 2 shows the performance of the same assets over the same windows, following three consecutive months or more of an improving global economic surprise index. This is consistent with our main hypothesis that global economic surprises are set to increase by early next year. Table 2Surprise Upticks And Subsequent Returns Surprise, Surprise Surprise, Surprise Using this method again shows no strong call for the Euro Area equity benchmark relative to the ACWI. There is a small improvement in performance, but Europe on average still underperforms, which reflects the thirteen years of a relative bear market in European equities. Similarly, results for European value stocks compared to growth equities are limited, as the sample is dominated by the structurally poor performance of value equities. However, this method highlights that the euro is likely to appreciate against the USD on both the three- and six-month investment horizon. This message is consistent with that of our Intermediate-Term Timing Model. Finally, this approach once again underscores the attractiveness of European small-cap equities on a three-, six-, and twelve-month investment horizon. Consequently, we maintain our buy recommendation on the euro. As we wrote three weeks ago, the near-term outlook for the common currency is fraught with risks and the low readings of the global economic surprise index confirm this reality.  Moreover, markets might enter a phase when they aggressively discount Fed rates hikes next year, which would further hurt the euro. However, the outlook for global growth will ultimately put a floor under EUR/USD. Chart 13Small-Caps: Almost There Small-Caps: Almost There Small-Caps: Almost There We also view European small-cap stocks as the premier equity vehicle in Europe over the coming 18 months because of their heightened pro-cyclicality.  However, the timing around shifting toward overweighing small-cap remains risky in the near-term, as they have not fully worked out the overbought conditions we flagged four weeks ago (Chart 13). Thus, we maintain small-cap equities on an upgrade alert, and we are looking to pull the trigger very soon.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com     Tactical Recommendations Surprise, Surprise Surprise, Surprise Cyclical Recommendations Surprise, Surprise Surprise, Surprise Structural Recommendations Surprise, Surprise Surprise, Surprise Closed Trades Image Currency Performance Fixed Income Performance Equity Performance

Highlights US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. If aggregate demand exceeds aggregate supply, the price level will rise. We argue that the US aggregate demand curve is currently quite steep. This implies that the price level may need to rise a lot to restore balance to the economy. In fact, if the aggregate demand curve is not just steep but upward-sloping, which is quite possible, there may be no price level that brings aggregate demand in line with supply; the US economy could go supernova. When supply is the binding constraint to growth, investors need to throw the old playbook for dealing with growth slowdowns out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. The Binding Constraint To Growth Is Now Supply After a post-Delta wave rebound in Q4, the US economy is expected to slow over the course of 2022. The Bloomberg consensus is for US growth to decelerate from 4.9% in 2021Q4 to 4.1% in 2022Q1, 3.9% in 2022Q2, 3.0% in 2022Q3, and 2.5% in 2022Q4. Growth in the first quarter of 2023 is expected to dip further to 2.3%. We agree that US growth will slow next year but think the market narrative around this slowdown is misguided. Chart 1Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand The standard market playbook for dealing with an economic slowdown is to position for lower bond yields, a stronger US dollar, and a decline in commodity prices. On the equity side, the playbook calls for shifting equity exposure from cyclicals to defensives, favoring large caps over small caps, and growth stocks over value stocks. There are two major problems with this narrative. First, growth is peaking at much higher levels than before and is unlikely to return to trend at least until the second half of 2023. Second, and more importantly, US growth will slow due to supply-side constraints rather than inadequate demand. US final demand will remain robust for the foreseeable future. Households are sitting on $2.3 trillion in excess savings, equivalent to 15% of annual consumption (Chart 1). The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 2). Banks are falling over themselves to make consumer loans (Chart 3). Chart 2Revolving Credit On The Rise Again Revolving Credit On The Rise Again Revolving Credit On The Rise Again Chart 3Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Banks Are Easing Credit Standards For Consumers Chart 4A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 4). As we discussed two weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Investment demand should remain strong. Business inventories are near record low levels (Chart 5). Core capital goods orders, a leading indicator for corporate capex, have soared (Chart 6). Chart 5Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Business Inventories Are Near Record Low Levels Chart 6Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Rise In Durable Goods Orders Bodes Well For Capex Chart 7The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Homeowner Vacancy Rate Is Signaling The Need For More Homebuilding The Dodge Momentum Index, which tracks planned nonresidential construction, rose to a 13-year high in October. The home­owner vacancy rate is at multi-decade lows, signifying the need for more homebuilding (Chart 7). While increased investment will augment the nation’s capital stock down the road, the short-to-medium term effect will be to inflate demand. Policy Won’t Tighten Enough To Cool The Economy What is the mechanism that will push down aggregate demand growth towards potential GDP growth? It is unlikely to be policy. While budget deficits will narrow over the next few years, the IMF still expects the US cyclically-adjusted primary budget deficit to be nearly 3% of GDP larger between 2022 and 2026 than it was between 2014 and 2019 (Chart 8). Chart 8 Chart 9The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation   As Matt Gertken, BCA’s Chief Geopolitical Strategist, writes in this week’s US Political Strategy report, the passage of the $550 billion infrastructure bill has increased, not decreased, the odds of President Biden and the Democrats passing their social spending bill via the partisan budget reconciliation process. On the monetary side, the Federal Reserve will finish tapering asset purchases next June and begin raising rates shortly thereafter. However, the Fed has no intention of raising rates aggressively. Most FOMC members see the Fed funds rate rising to only 2.5% this cycle (Chart 9). The “dots” call for only one rate hike in 2022 and three rate hikes in both 2023 and 2024. Investors expect rates to rise even less by end-2024 than the Fed foresees (Chart 10).   Chart 10 The Inflation Outlook Hinges On The Slope Of The Aggregate Demand Curve If policy tightening will not suffice in cooling demand, the economy will overheat and inflation will rise. But by how much will inflation increase? The answer is of great importance to investors. It also hinges on a seemingly technical question: What is the slope of the aggregate demand curve? As Chart 11 illustrates, prices will rise more if the aggregate demand curve is steep than if it is flat. Chart 11 Chart 12Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s Wages Rose Faster Than Prices During The Inflationary Late-60s and 70s It is tempting to think of the aggregate demand curve in the same way one might think of the demand curve for, say, apples. When the price of apples rises, there is both a substitution and an income effect. An increase in the price of apples will cause shoppers to substitute away from apples towards oranges. In addition, if apples are so-called “normal goods,” shoppers will buy fewer apples in response to lower real incomes. This chain of reasoning breaks down at the aggregate level. When economists say the price level has risen, they are referring to all prices; hence, there is no substitution effect. Moreover, since one person’s spending is another’s income, rising prices do not necessarily translate into lower overall real incomes. Granted, if nominal wages are sticky, as they usually are in the short run, an unanticipated increase in prices will reduce real wage income. However, this will be offset by higher business income. Over time, wages tend to catch up with prices. In fact, wage growth usually outstrips price growth during inflationary periods. For example, real wages rose during the late-1960s and 70s but fell during the disinflationary 1980s (Chart 12). Textbook Reasons For A Downward-Sloping Aggregate Demand Curve According to standard economic theory, there are three main reasons why aggregate demand curves are downward-sloping: The Pigou Effect: Higher prices erode the purchasing power of money, resulting in a negative wealth effect. The Keynes Effect: Higher prices reduce the real money supply. This pushes up real interest rates, leading to lower investment spending. The Mundell-Fleming Effect: Higher real rates push up the value of the currency, causing net exports to decline. None of these three factors are particularly important for the US these days. Chart 13Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Base Money Has Swollen Since The Subprime Crisis Strictly speaking, the Pigou wealth effect applies only to “base money,” also known as “outside money.” Outside money includes cash notes, coins, and bank reserves. Inside money such as bank deposits are not included in the Pigou effect because while an increase in consumer prices decreases the real value of bank deposits, it also decreases the real value of commercial bank liabilities.1  In the US, the monetary base has swollen from 6% of GDP in 2008 to 28% of GDP as a result of the Fed’s QE programs (Chart 13). Nevertheless, even if one were to generously assume a wealth effect of 10% from changes in monetary holdings, this would still imply that a 1% increase in consumer prices would reduce spending by only 0.03% of GDP. Simply put, the Pigou effect is just not all that big. Chart 14 In contrast to the Pigou effect, the Keynes effect has historically had a significant impact on the business cycle. However, the importance of the Keynes effect faded following the Global Financial Crisis as the Fed found itself up against the zero lower bound on interest rates. When interest rates are very low, there is little to distinguish money from bonds. Rather than holding money as a medium of exchange (i.e., for financing transactions), households and businesses end up holding money mainly as a store of wealth. In the presence of the zero bound, the demand for money becomes perfectly elastic with respect to the interest rate (Chart 14). As a result, changes in the real money supply have no effect on interest rates, and by extension, interest-rate sensitive spending. And if a decline in the real money supply does not push up interest rates, this undermines the Mundell-Fleming effect as well. Could The Aggregate Demand Curve Be Upward-Sloping? The discussion above, though rather theoretical in nature, highlights an important practical point: The aggregate demand curve may be quite steep. This means that the price level might need to rise a lot to equalize aggregate demand with aggregate supply. Chart 15US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows In fact, one can easily envision a scenario where a rising price level boosts spending; that is, where the demand curve is not just steep but upward-sloping. One normally assumes that higher inflation will prompt central banks to raise rates by more than inflation has risen, leading to higher real rates. However, if the Fed drags its feet in hiking rates, as it is wont to do given its concerns about the zero bound, rising inflation will translate into a decline in real rates. Lower rates will boost demand, leading to higher inflation, and even lower real rates. In addition, lower real rates will benefit debtors, who tend to have a higher marginal propensity to spend than creditors. This, too, will also boost aggregate demand. It is striking in this regard that real bond yields hit a record low this week, with the 10-year TIPS yield falling to -1.17% and the 30-year yield drooping to -0.57% (Chart 15). Black Holes Vs. Supernovas Chart 16 In the case where the aggregate demand curve is upward-sloping, there is no stable equilibrium (Chart 16). If demand falls short of supply, demand will continue to shrink as the price level declines, leading to ever-rising unemployment. Unless policymakers intervene with stimulus, the economy will sink into a deflationary black hole. In contrast, if demand exceeds supply, demand will continue to rise as the price level increases exponentially. The economy will go supernova. Tick Tock Young stars fuse hydrogen into helium, releasing excess energy in the process. After the star has run out of hydrogen, if it is big enough, it will start fusing helium into heavier elements such as carbon and oxygen. The process of nucleosynthesis continues until it reaches iron. That is the end of the line. Fusing elements heavier than iron requires a net input of energy. Unable to generate enough external pressure through fusion, the star loses its battle to gravity. The core collapses, spewing material deep into interstellar space (a good thing since your body is mainly made from this stardust). Observing the star from afar, one would be hard-pressed to see anything abnormal until it explodes. The path to becoming a supernova is highly non-linear. The same is true for inflation. Just like a star with an ample supply of hydrogen, the Fed can burn through its credibility for a while longer. During the 1960s, it took four years for inflation to take off after the economy had reached full employment (Chart 17). By that time, the unemployment rate was two percentage points below NAIRU. Most of today’s inflation is confined to durable goods. This is not a sustainable source of inflation. The durable goods sector is the only part of the CPI where prices usually fall over time (Chart 18). Chart 17Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Inflation Spiked In The 1960s Only Once The Unemployment Rate Had Fallen Far Below Equilibrium Chart 18Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time Inflation Has Been Concentrated In Durable Goods, A Sector Where Prices Usually Fall Over Time To get inflation to go up and stay up in modern service-based economies, wages need to rise briskly. While US wage growth has picked up, the bulk of the increase has been among low-wage workers, particularly in the services and hospitality sector (Chart 19). Chart 19Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution The most likely scenario for next year is that firms will simply ration output, fearful that raising prices too quickly will hurt brand loyalty and trigger accusations of price gouging. Shortages will persist, but this time they will be increasingly concentrated in the service sector. Such a state of affairs will not last, however. Competition for workers will cause wages to rise much more than they have so far. Keen to protect profit margins, firms will start jacking up prices. A wage-price spiral will develop. The US economy could go supernova. Investment Conclusions Chart 20Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone Long-Term Inflation Expectations Are Near The Bottom End Of The Fed's Comfort Zone US growth will slow next year, not because demand will falter, but because supply-side constraints will prevent the economy from producing as much output as households and businesses want to buy. This means that the old playbook for dealing with growth slowdowns needs to be thrown out the window. Rather than positioning for lower bond yields, investors should position for higher yields. Rather than expecting a stronger dollar, investors should expect a weaker one. Rather than favoring growth stocks, large caps, and defensives, investors should favor value stocks, small caps, and cyclicals. While inflation expectations have recovered from their pandemic lows, the 5-year/5-year forward TIPS breakeven inflation rate is still near the bottom end of the Fed’s comfort zone (Chart 20). Rising inflation expectations will lift long-term bond yields, justifying a short duration stance in fixed-income portfolios. Higher bond yields will benefit value stocks. Chart 21 shows that there has been a strong correlation between the relative performance of growth and value stocks and the 30-year bond yield this year. Rising input prices will make the US export sector less competitive, leading to a weaker dollar. Historically, non-US stocks have done well when the dollar has been weakening (Chart 22). Chart 21The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance of Value Stocks Has Closely Tracked Bond Yields This Year Chart 22Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening As for the overall stock market, with the Fed still in the dovish camp, it is too early to turn negative on equities. An equity bear market is coming, but not until rising inflation forces the Fed to step up the pace of rate hikes. That will probably not happen until mid-2023. Short Gilt Trade Activated We noted last week that we would go short the 10-year UK Gilt if the yield broke below 0.85%. Our limit order was activated on November 5th and we are now short this security.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  To distinguish between inside and outside money, one should ask where the liability resides. If the liability resides within the private sector, it is inside money. By convention, central bank reserves are classified as outside money. However, one could argue that since taxpayers ultimately own the central bank, an increase in the price level will benefit taxpayers by eroding the real value of the central bank’s liability. If one were to take this view, the Pigou effect would be even weaker. Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image