Fixed Income

Highlights Fed: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. We expect Fed rate hikes to start in December 2022 and that the pace of hikes will proceed more quickly than is currently priced in the yield curve. Duration: Investors should maintain below-benchmark portfolio duration in anticipation of a rate hike cycle starting in December 2022. Yield Curve: Investors should position in Treasury curve flatteners. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Feature Chart 1Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 One of our themes this year is that US bond investors should pay more attention to the employment data than the inflation data.1 This is because the Fed has successfully convinced markets that it will not lift rates until “maximum employment” is achieved, even if inflation is strong.2 This story has played out during the past few months as bond yields have remained low despite surging prices (Chart 1). Our view is that the muted reaction in bonds is due to the widespread belief that the labor market remains far from “maximum employment” and that rate hikes are therefore a long way off. In this environment, only surprisingly strong employment prints can upset the market’s narrative and send bond yields higher. This playbook for the bond market will continue to function for the next few months. Strong employment data will pull bond yields higher and disappointing employment data will push them down. Inflation prints will be largely irrelevant for the market. But this will change next year. In fact, we see the employment data taking a back seat to the inflation data in the minds of bond investors in 2022. A More Explicit Definition of “Maximum Employment” Must Emerge In 2022 Almost everyone agrees that the US labor market is far from “maximum employment” today, but that will no longer be the case in 2022. The Appendix to this report shows the average monthly nonfarm payroll growth that is required to reach different possible definitions of “maximum employment” by a few specific future dates. For example, we calculate that average monthly nonfarm payroll growth of 414 thousand would cause the unemployment rate to reach 3.8% and the labor force participation rate to reach 63% by the end of 2022. Our sense is that the US economy will be able to add more than 414 thousand jobs per month between now and December 2022. This means that if Fed officials believe that an unemployment rate of 3.8% and a participation rate of 63% meet the definition of “maximum employment”, then they will start to lift interest rates by then. This example sets the scene for what will become next year’s most important monetary policy debate. What constitutes “maximum employment”? Does our example of a 3.8% unemployment rate and a 63% participation rate meet the definition? Or does the Fed have different targets in mind? The Fed will be forced to clarify its position on the topic as the labor market gets closer to reasonable definitions of “maximum employment”. Our sense is that, as of now, there are a range of views on the committee with some FOMC participants taking a more hawkish view of how much slack is left in the labor market and some adopting a more dovish posture. We outline the differences between the hawkish and dovish positions below, but ultimately the path of inflation in 2022 will determine which camp wins out. If inflation remains high next year, then the Fed will be quicker to declare that the labor market is at “maximum employment”, and vice-versa. The Fed’s reliance on the inflation data to settle the argument of what constitutes “maximum employment” will make inflation the most important economic indicator for bond yields in 2022. Labor Market Slack: The Hawkish Case Chart 2The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The hawkish case for the US labor market reaching “maximum employment” sooner rather than later was outlined nicely last month by our own Bank Credit Analyst.3 First, the Bank Credit Analyst points out that the US labor market was likely beyond “maximum employment” before COVID-19 struck. The implication being that the Fed may move to lift interest rates before the unemployment and participation rates fully recover their pre-pandemic levels. Notice that the unemployment rate (adjusted for the post-COVID surge in people employed but absent from work) was 3.5% in February 2020, well below the Congressional Budget Office’s 4.5% estimate of the natural rate of unemployment (Chart 2).4 Today, the adjusted unemployment rate is 5.5%, not that far above the 3.5%-4.5% range of FOMC participant estimates of the natural rate. If this year’s rate of decline continues, the unemployment rate will hit 4.5% by January 2022 and 3.5% by May 2022. Of course, we know that the Fed takes a broader view of labor market utilization than just the unemployment rate. In particular, we observed sharp declines in labor force participation rates across a wide range of demographic groups when the pandemic struck last year (Chart 3). While the Fed will want to see some improvement in labor force participation, it might be unrealistic to expect the overall labor force participation rate to return to its pre-pandemic level. This is because the aging of the US population imparts a structural downtrend to the participation rate. The dashed line in Chart 4 shows where the participation rate would be if the rate of labor force participation of every individual age cohort remained constant at its February 2020 level. Even in this case, the greater flow of people into the older age groups causes the part rate to fall over time. The message from Chart 4 is that even if the participation rates of every age cohort tracked by the Bureau of Labor Statistics rebound to their February 2020 levels, we would still only expect an overall participation rate of 62.8% by the end of 2022, significantly below the 63.3% seen in February 2020. Chart 3Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Chart 4The Demographic Downtrend In Participation The Demographic Downtrend In Participation The Demographic Downtrend In Participation On top of the demographic argument, we also notice that the pandemic led to a surge in the number of retired people last year, a number that continues to rise quickly (Chart 5). While we should probably expect some increase in the flow of people coming out of retirement to re-join the labor force as the economy recovers, it’s also logical to assume that there will be at least some hysteresis among the retired population. That is, the longer someone is retired, the less likely they are to re-enter the labor force at all. To the extent that the increase in retired people is sticky, it may be ambitious to expect a full convergence of the 55-year+ part rate back to February 2020 levels (Chart 3, bottom panel). All else equal, this will cause the labor market to reach “maximum employment” more quickly than even our demographic trendline for participation suggests. Chart 5A Surge In Retirees A Surge In Retirees A Surge In Retirees The question of how many FOMC participants agree with the above arguments remains open, but our sense is that there are some who will be eager to declare that “maximum employment” has been achieved before we see a full rebound in the unemployment and participation rates back to pre-COVID levels. For example, Fed Vice-Chair Richard Clarida mentioned the “demographic trend” in labor force participation in his most recent speech.5 Also, Dallas Fed President Robert Kaplan said the following in a recent interview: We’ve had 3 million retirements since February 2020. […] Some of these workers will come back into the workforce, but some of these workers are 55 and older and they’re in reasonably good financial shape and COVID has caused them to re-think whether they really want to re-enter the workforce.6 Labor Market Slack: The Dovish Case There are also good arguments on the side of those who think that an appropriate definition of “maximum employment” involves an unemployment rate closer to 3.5% than 4.5% and a participation rate that does return to pre-COVID levels, and maybe even moves higher. First, a study from the Federal Reserve Bank of Kansas City noted that the bulk of the recent increase in the number of retired people is explained, not by an increase in the number of retirements, but by a reduction in the flow of people from retirement back into the workforce (Chart 6).7 This suggests that pandemic-related health risks are the likely culprit behind the increase in the number of retired people, casting doubt on the idea that the increase in retired people will be sticky. Chart 6Increased Retirees: A Closer Look 2022 Will Be All About Inflation 2022 Will Be All About Inflation Second, there is a strong case to be made that even the February 2020 labor force participation rate is not high enough to meet the definition of “maximum employment”. If we look at the participation rates for 25-54 year old men and women, we see that both were in strong uptrends prior to the pandemic (Chart 7), and there is every reason to believe that they would have continued to move higher if COVID hadn’t cut the recovery short. Chart 7Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Consider what some FOMC participants were saying prior to the pandemic: The strong labor market is also encouraging more people in their prime working years – ages 25 to 54 – to rejoin or remain in the labor force, […] So far, we have made up more than half the loss in the Great Recession, which translates to almost 2 million more people in the labor force. But prime age participation could still be higher. - Jerome Powell, November 20198 Whether participation will continue to increase in a tight labor market remains to be seen. But I note that male prime-age participation still remains below levels seen in previous business cycle expansions. - Richard Clarida, November 20199 In a more recent interview, Minneapolis Fed President Neel Kashkari expressed skepticism about the idea that labor force participation is destined to remain in a long-run structural downtrend and said that he’s “not convinced we were actually at maximum employment before the COVID shock hit us.” He also said: Getting [labor force participation] and employment-to-population at least back to where they were before [the pandemic], but not necessarily even declaring victory when we do that. I think that’s a reasonable thing for us to try to achieve.10   Inflation: The Ultimate Argument Settler What the above arguments make clear is that there are good reasons to think that the US labor market will reach some policymakers’ definitions of “maximum employment” perhaps by as early as the middle of next year. However, there are also some policymakers who will adopt a more dovish view of what constitutes “maximum employment”. Ultimately, the path of inflation will determine which camp wins out. This is because the entire concept of “maximum employment” is only meaningful when viewed alongside inflation. If employment is pushed beyond its “maximum”, it definitionally means that labor market tightness is leading to unwanted inflationary pressures. With that in mind, the Fed will increasingly refer to the inflation data next year as it tries to make its definition of “maximum employment” more precise. Crucially, what will matter for the Fed (and for the bond market) is where inflation is next year, not where it is right now. Right now, core inflation is well above the Fed’s price stability target, but it is well known that the recent increase in inflation is concentrated in a few sectors – COVID-impacted services and autos – where prices will decelerate as post-pandemic bottlenecks ease (Chart 8). Just as the Fed ignored surging prices in those sectors this year, it will ignore plunging prices in those sectors next year. What will matter for monetary policy is whether core inflation excluding COVID-impacted services and autos remains contained or rises above levels consistent with the Fed’s target (Chart 8, bottom panel). The Fed will also be inclined to declare that “maximum employment” has been achieved if wage growth is accelerating. Currently, there is some evidence of rising wages but also some major supply bottlenecks in the labor market, as evidenced by the all-time high in job openings (Chart 9). Labor supply constraints should ease next year, but the Fed will be watching closely to see if wage growth moderates in kind or continues to increase. Chart 8Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Chart 9Watch Wages In 2022 Watch Wages In 2022 Watch Wages In 2022 Finally, the Fed will keep a close eye on inflation expectations next year. In particular, it will monitor the Common Inflation Expectations Index and the 5-year/5-year forward TIPS breakeven inflation rate (Chart 10). If either of these indicators break above levels consistent with the Fed’s 2% inflation target, then policymakers will be more inclined to think that “maximum employment” has been attained. Chart 10Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Bottom Line: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. The key indicators to monitor to decide when the Fed will declare that “maximum employment” has been attained are: core inflation excluding COVID-impacted services and autos, wage growth, inflation expectations and the prime-age (25-54) labor force participation rate (Chart 3, panel 2). Investment Implications For bond markets, the question of when the Fed decides that the labor market has reached “maximum employment” is crucial because it will determine the start of the next rate hike cycle. At present, the overnight index swap curve is priced for Fed liftoff in January 2023 and for a total of 78 bps of rate hikes by the end of 2023 (Chart 11). Chart 11Rate Hike Expectations Rate Hike Expectations Rate Hike Expectations Our expectation is that the Fed will start lifting rates in December 2022 and that rate hikes will proceed more quickly than what is currently priced in the market. The unemployment rate will be close to 3.5% by December 2022 and inflation will be sufficiently above the Fed’s target that policymakers will be inclined to view the labor market as at “maximum employment”. Investors should run below-benchmark duration in US bond portfolios to profit from this outcome. We also recommend that investors position for a flatter yield curve by the end of 2022. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Table 1A shows fair value estimates for the 2-year, 5-year and 10-year yields as of the end of 2022 assuming the market moves to price-in the following path for the fed funds rate: The first 25 bps rate hike occurs in December 2022 Rate hikes proceed at a pace of 100 bps per year The fed funds rate levels-off at a terminal rate of 2.08%11 Table 1ATreasury Curve Fair Value Estimates: December 2022 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation In that example, the 2-year and 5-year yields both rise by much more than the 10-year yield and both exceed the change that is priced into the forward curve by more than the 10-year yield. Table 1B shows the results from a similar scenario, the only difference is that the liftoff date is pushed back to March 2023. Both the 2-year and 5-year yields also rise by more than the 10-year yield in this scenario, though the delayed liftoff dampens the relative upside in the 2-year yield. Table 1BTreasury Curve Fair Value Estimates: March 2023 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation Bottom Line: Investors should maintain below-benchmark portfolio duration and position in Treasury curve flatteners in anticipation of a rate hike cycle that will start in December 2022. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +414k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents 2022 Will Be All About Inflation 2022 Will Be All About Inflation Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Watch Employment, Not Inflation”, dated June 15, 2021. 2 Specifically, the Fed’s forward guidance states that it will not lift interest rates until (i) inflation is above 2%, (ii) inflation is expected to remain above 2% for some time and (iii) the labor market has reached “maximum employment”. 3 Please see Bank Credit Analyst Special Report, “The Return To Maximum Employment: It May Be Faster Than You Think”, dated August 26, 2021. 4 For details on the adjustment we make to the unemployment rate please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021. 5 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm 6  https://www.bloomberg.com/news/articles/2021-08-09/dallas-fed-president-rob-kaplan-on-the-economy-and-monetary-policy-right-now?sref=Ij5V3tFi 7 https://www.kansascityfed.org/research/economic-bulletin/what-has-driven-the-recent-increase-in-retirements/ 8 https://www.federalreserve.gov/newsevents/speech/powell20191125a.htm 9 https://www.federalreserve.gov/newsevents/speech/clarida20191114a.htm 10 https://www.bloomberg.com/news/articles/2021-08-16/neel-kashkari-on-the-fed-s-quest-to-get-to-full-employment?srnd=oddlots-podcast&sref=Ij5V3tFi 11 We assume a target range of 2% to 2.25% for the terminal fed funds rate. We also assume that the effective fed funds rate trades 8 bps above the lower-end of its target band, as is presently the case. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

9 September 2021 at 10:00 EDT Emerging Markets Strategy/Webcast EM/China: See The Forest For The Trees 9 September 2021 at 21:00 EDT Emerging Markets Strategy/Webcast Emerging Asia: See The Forest For The Trees Highlights Structural inflation in India has abated noticeably since the mid-2010s. The cyclical inflation outlook is also benign (Chart 1). As such, the specter of inflation does not pose a material threat to this stock market. Indian stocks’ high valuation is a risk; yet this bourse’s structurally high premium relative to EM will likely continue as India’s earnings growth will stay strong and its volatility low. Investors should stay overweight Indian stocks in an EM equity portfolio, and local currency bonds in an EM domestic bond portfolio. Feature Chart 1India's Cyclical Inflation Outlook Is Benign Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? In a recent Emerging Markets Strategy report we showed that India stands out as the only country in Asia with rather high inflation. Indeed, core CPI in India, at about 6%, is higher than all other major EM and DM countries, save Turkey and Russia. The question is, with the economy re-opening, will Indian inflation rise further and thus derail the rally in Indian equities? Our research indicates that both the structural and cyclical inflation outlook for India remains benign. Our models for headline and core CPI both point to lower inflation in the coming months (Chart 1). As such, inflation is unlikely to pose any major threat to Indian assets in the foreseeable future. Investors should remain overweight Indian stocks in an EM equity portfolio. Fixed-income investors should also continue to overweight Indian local bonds in an EM domestic bond portfolio. Currency traders should favor the rupee versus its EM peers. Inflation Outlook: Structural … The first of the two principal drivers of India’s structural inflation trend is the country’s productivity. The stronger the productivity gains, the more contained has been its structural inflation.   The second major driver is broad money supply. The higher the money growth, the steeper have been inflationary pressures – especially during those periods when productivity gains were timid. Top panel of Chart 2 shows that up until the early-2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. That period was also marked by very strong broad money growth: at times, the latter would rise to 20% annually (Chart 2, bottom panel). This growth was due to chronically high fiscal deficits that were monetized, coupled with intermittent surges in bank credit. Chart 2Slower Money Supply Amid Decent Productivity Led To A Structural Decline In Inflation Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The consequence of persistently low productivity gains amid strong money supply was structurally high inflation, with occasional flare-ups well into double digits (Chart 2). Chart 3Steady Fall In Budget Deficits In Post-GFC Era Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? From the early 2000s, however, that dynamic began to change. A surge in capital spending in infrastructure and other productive capacity propelled India’s productivity trend up by several notches. In the past 15 years, the productivity growth rate has averaged around 6% a year; even though more recently that rate has slowed. In the post-GFC period, both major sources of money creation were stymied. First, successive Indian governments, regardless of political affiliation, adopted a rather tight fiscal policy. They reined in fiscal outlays substantially. Non-interest expenditures of the central government fell from 14% of GDP in 2010 down to 9% by 2019, just before the pandemic (Chart 3, top panel). As a result, during that period, fiscal and primary deficits narrowed significantly: from almost 7% of GDP to 3%, and from almost 4% of GDP to nearly zero, respectively (Chart 3, bottom panel). In addition, a myriad of reasons1 caused commercial bank credit to decelerate materially – from as high as 30% before the GFC to a mere 6% by 2019. The upshot of all this was a secular decline in broad money growth. That eventually led India’s inflationary pressures to decline structurally since the mid-2010s (Chart 2, bottom panel, above). Going forward, those major drivers (both productivity and money growth) will warrant a benign inflation outlook. The country has been continuing its high capital spending for over a decade now (around 30% to 35% of GDP, a rate second only to China). This year, India’s capital spending has already revived. Other corroborating indicators such as imports of capital goods have also recovered robustly. This indicates a new capex cycle is unfolding. Therefore, odds are that the productivity growth rate will stay decent. Prudent fiscal policy, on the other hand, will keep the money growth in check. Chart 4Low Wages Will Help Keep Inflation Subdued Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Finally, wage pressures in India will also stay muted. In rural areas, both farm and non-farm nominal wages have been growing at a very slow pace; and are now flirting with outright contraction (Chart 4, top panel). Industrial wage expectations have also been tepid over the past several years (Chart 4, bottom panel). The broader picture is unlikely to change in the future as tens of millions of young people continue to join the work force every year. Taken together, these factors point to subdued structural inflation ahead. … And Cyclical The chance that inflation in India will flare up over a cyclical horizon (12 months) is also low: First, one of the major cyclical drivers of inflation in India, the government’s food procurement prices (called Minimum Support Price or MSP) have stayed low for the past several years. The announced MSPs for some of the crops for the 2021-22 agriculture season (July-June) have also shown no marked increase. This will surely help keep the wholesale prices for food in check, which, in turn, will keep a lid on consumer inflation expectations and ultimately on both headline and core consumer inflation (Chart 5). Second, the country’s money growth is also unlikely to witness an immediate, major boom. While the budget deficit has swelled over the past year or so, odds are that the government will revert to the tighter fiscal stance that prevailed over the past decade – as soon as the pandemic is brought under control. Chart 6 shows that government non-interest spending leads core CPI. Reduced expenditure growth will cap inflation. Chart 5Low Food Prices Will Keep A Lid On Inflation Expectations Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 6Slowing Fiscal Spending Will Cap Core Inflation Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 7Fuel Price Inflation Is Set To Decelerate Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The other contributor to money growth, bank credit, is expected to accelerate; but its expansion will not be rapid as banks are still suffering from elevated NPLs. Third, fuel price inflation has likely peaked in India. Last year authorities imposed substantial new taxes on local gasoline and diesel prices, which artificially raised consumer inflation (Chart 7). Since there is little chance of new fuel levies this year and given that crude prices are unlikely to rise much from the current levels (which is EMS’s view), fuel inflation will subside materially next year. And as fuel costs often eventually spill into core inflation, this deceleration will help check the latter as well. Finally, given the massive negative output gap that opened up in the economy during the pandemic-related lockdowns, it will take a while before the economy overheats again. Odds are therefore low that India’s inflation will accelerate much in the coming months. Notably, our cyclical inflation models for both headline and core CPI – built using the drivers discussed above – also vouch for a modest decline in inflation (Chart 1, on page 1). Does Inflation Hurt Stocks? Currently, the Indian economy is not plagued by any major excesses and therefore has no major macro vulnerability. The only potential vulnerability that the economy and stock markets face stem from any possible rise in inflation. Notably, the primary driver of Indian stocks is economic growth and corporate profits. Historically, inflation (CPI) in low- and mid-single digits did not hurt Indian stocks. However, once inflation approached a high-single digit mark (usually 8%), a sell-off in stocks typically occurred. Chart 8 shows that, during India’s high-inflation era (from 1994 to 2013), every time CPI breached the 8% mark (the dotted line in the chart), stocks fell in absolute USD terms, or at the minimum, were weak. Chart 8Indian Stocks Faced Major Headwinds When Headline CPI Approached 8% Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 9In Recent Years Inflation Has Ceased To Be A Headwind For Indian Stocks Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Interestingly, the above correlations have changed dramatically since 2014. The top panel of Chart 9 shows that core CPI does not have any steady correlation with stock prices anymore. And core PPI, in fact, has developed a strong positive correlation with stocks (Chart 9, bottom panel) – in complete reversal of the dynamics that prevailed in the previous two decades. The adverse impact of inflation on stock prices is via multiple compression, as rising interest rates lead to equity de-rating. What’s notable is that the multiple compressions do not begin as soon as a rate hike cycle commences. Rather, it takes a meaningful rise in interest rates before it starts to hurt multiples (Chart 10). Given the above, one can expect a material multiple compression only if inflation rises a few notches above the central bank’s target (Chart 11). The odds of that happening now are low. Therefore, policy rates will remain lower for longer, and stock valuations will remain at a higher level than usual. Chart 10Interest Rates Usually Needed To Rise Several Points Before Stock Multiple Compression Began Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 11India's Inflation Remains Within RBI Target Bands Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart?   Incidentally, thanks to material rate cuts, real interest rates paid by Indian firms – deflated by both core producer and core consumer prices – have plummeted. Lower real rates benefit the borrowers (i.e., non-financial listed companies) (Chart 12). The bottom line is that, with India’s inflation now being both structurally low (by Indian history) and cyclically tame, it is unlikely to be a cause of any major equity sell-off. Are Indian Equity Valuations Justified? With a trailing P/E of 31, and P/Book of 3.9, there is no doubt that Indian stocks are expensive. Yet, part of the multiple expansion in India, like most other DM countries, has been a direct outcome of a sharply lower policy rate, as discussed above. Incidentally, if one were to look at the cyclically adjusted valuation measures (CAPE), Indian markets appear to be only moderately expensive (Chart 13, top panel). Chart 12Lower Real Rates Boost Firms' Profits And Warrant Higher Stock Prices Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 13Cyclically-Adjuted P/E Ratio Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 14Relative Equity Multiples: India vs. EM Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? In terms of relative valuation vis-à-vis the rest of the EM, Indian stocks continue to command a high premium: around 90% in the case of P/E and P/Book multiples. (Chart 14). In terms of cyclically adjusted valuation (CAPE) relative to the EM, India also appears to be quite pricey (Chart 13, bottom panel). The bottom line is that Indian stocks are expensive; and that is a risk to this bourse. A pertinent question here is whether India still merits the structurally high premium that it has enjoyed over the years relative to its peers. Our answer is in the affirmative. One reason this bourse has continued to enjoy a high premium, especially since the mid-2000s, is because the growth of Indian corporate earnings has been superior to those of most other EM countries. But more importantly, the volatility of those earnings has been much lower than its peers. These strong, yet less volatile earnings are what investors have been willing to pay a premium for. Going forward, we see both traits remaining intact. Long-term growth in India will likely stay as one of the highest in the EM world. Earnings volatility is also unlikely to change anytime soon. The reason is, first, lower inflation going forward will entail relatively lower interest rate volatility, and therefore, lower business cycle / earnings volatility. Second, India’s currency volatility will also likely stay lower. Part of the reason is the near absence of foreign investors on government bonds in India. This has precluded India from suffering a major currency sell-off during global risk-off episodes – as few bond investors head for the exit. We discussed this and several other issues related to Indian bond markets and the rupee in much greater detail in our last report on India. Taken together, lower volatility in both local currency earnings and the exchange rate entails lower overall volatility for US dollar-denominated earnings. That will help Indian stocks’ premium to stay elevated beyond any short-term fluctuations. Inflation And The Rupee Chart 15The Rupee Strengthens When Relative Inflation In India Versus US Decelerates Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The impact of inflation on the rupee is nuanced. It’s not the absolute level of India’s CPI or PPI that affects the rupee-dollar exchange rate; it’s the relative inflation between these two economies that does so. Chart 15 shows that the rupee usually strengthens versus the dollar when inflation in India falls relative to that of US (shown in inverted scale in the chart). These relative inflation dynamics could also provide insight into the exchange rate outlook. Chart 16 shows that the rupee is currently 10% cheaper when measured against what would be its “fair value” (Chart 16, bottom panel). The fair value has been derived from a regression analysis of the exchange rate on the manufacturers’ relative producer prices of the two countries. Investment Recommendations Indian stocks have decisively broken out both in absolute terms and relative to their EM counterparts (Chart 17). Notably, the outperformance is not just due to a sell-off in Chinese TMT stocks. It is even more impressive relative to the ‘mainstream EM’ bourses (i.e., EM excluding China, Taiwan and Korea). Given India’s relatively superior structural and cyclical backdrops, this outperformance should continue for a while (Chart 17, bottom two panels). Investors should stay overweight this bourse in an EM equity portfolio. Chart 16The Indian Rupee Is Now About 10% Below Its Fair Value Versus The US Dollar Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 17Indian Stocks' Breakout Is Decisive And The Relative Outperformance Is Broad-based Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? Chart 18Higher Carry And A Better Currency Outlook Will Lead To Indian Domestic Bonds' Outperformance Can Inflation Upset The Indian Applecart? Can Inflation Upset The Indian Applecart? The medium-term outlook for the rupee is also positive. The currency is cheap and competitive –an added incentive for both foreign direct investors and portfolio investors. Finally, Indian domestic bonds offer value – both relative to their EM peers and the US treasuries. 10-year government bonds yields, at 6.2%, offer an enticing 480 basis points over similar duration US Treasuries. Given the sanguine rupee and inflation outlooks, Indian bonds will likely continue to outperform EM local bonds (Chart 18). Investors should stay on with our recommendation of overweighting India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 The reasons include a surge in bank NPLs, lack of bankable projects, a kind of policy paralysis resulting in delay in various regulatory clearances for capital projects etc.

Highlights The equity risk premium has turned negative for the first time since 2002. It follows that any significant rise in bond yields will cause risk-asset prices to collapse, quickly flipping any incipient inflationary shock into a deflationary shock. Shorting bonds yielding 2 percent is a ‘widow maker’ trade, as anybody who has tried this with a long list of government bonds has learned to their cost, the most recent being UK gilts. Hence, the next on the list for the ‘widow maker’ is shorting the US 30-year T-bond which is now yielding 2 percent. In fact, the US 30-year T-bond is a must-own structural investment. Fractal analysis: Medical equipment versus healthcare services. Feature Chart of the WeekThe Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 The Equity Risk Premium Turns Negative For The First Time Since 2002 Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. For example, the US 10-year Treasury Inflation Protected Security (TIPS) and the UK 10-year index linked gilt are yielding -1.3 percent and -2.8 percent respectively. Meaning that anybody who buys and holds these bonds to redemption is guaranteed a deeply negative 10-year real return. Meanwhile, in nominal yield space, 10-year government bonds yield -0.35 percent in Germany and Switzerland, 0.7 percent in the UK, and 1.3 percent in the US. What about equities? Unlike a bond’s redemption yield, equities do not offer a guaranteed long-term return for buy-and-hold investors. So, some analysts assume that the equity market’s earnings yield is the proxy for this long-term return. According to these analysts, the US equity market’s earnings yield of 4.4 percent means that it will deliver a prospective long-term real return of 4.4 percent per annum. Compared to the 10-year TIPS real yield of -1.3 percent, they argue that this offers an excess return or ‘equity risk premium’ of a comfortable +5.7 percent. Therefore, claim these analysts, equities are reasonably valued, relative to bonds, and in absolute terms.  But as we will now demonstrate, this analysis is deeply flawed. The Equity Risk Premium Has Turned Negative The equity market’s earnings yield is a valuation metric, so clearly there is some connection between it and the prospective return delivered by the equity market. Nevertheless, the crucial point to grasp is that: The equity market’s earnings yield does not equal its prospective return. Charts I-2 - I-3 should make this point crystal clear. As you can see, the earnings yield rarely equals the delivered prospective 10-year return, either real or nominal. When the earnings yield is elevated, the prospective return turns out higher. Conversely, when the earnings yield is depressed, as now, the prospective return turns out to be much lower. Chart I-2The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... Chart I-3...Or In Nominal ##br##Terms ...Or In Nominal Terms ...Or In Nominal Terms Therefore, to take the current earnings yield of 4.4 percent and subtract the real bond yield of -1.3 percent to derive an equity risk premium of +5.7 percent is analytically flawed, just as it is analytically flawed to subtract apples from oranges. To derive the equity risk premium, the correct approach is first to translate the earnings yield into a prospective 10-year return based on the established mathematical relationship between these variables. Chart I-4 does this and shows that, based on a very tight mathematical relationship through the past thirty five years, an earnings yield of 4.4 percent translates into a prospective 10-year nominal return of just 1 percent. Chart I-4We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... We Must Mathematically Map The Earnings Yield Into A Prospective Return... Having translated the earnings yield into a prospective 10-year nominal return of 1 percent, we can now make an apples-for-apples comparison with the 10-year T-bond yield of 1.3 percent (Chart I-5). Chart I-5...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield ...And Only Then Subtract The Bond Yield Derived correctly therefore, the equity risk premium has turned negative for the first time since 2002 (Chart of the Week). We deduce that the equity market is very richly valued both in absolute terms and relative to bonds. And crucially, that this rich valuation is contingent on bond yields remaining ultra-low, or going even lower. Shorting Bonds Yielding 2 Percent Is A ‘Widow Maker’ All of which brings us to one of the most pressing questions we get from clients. When a bond is offering a feeble yield, what is the point in owning it? Maybe the best people to answer are the casualties of the now infamous ‘widow maker’ trades. The original widow maker trade was the idea that the yield on the Japanese Government Bond (JGB), at 2 percent, was so feeble that there was no point in owning it. Furthermore, with massive Japanese fiscal stimulus coming down the pike, the ‘no-brainer’ investment strategy was not just to disown the JGBs, but to take an outright short position, as it seemed that the only direction that JGB yields could go was up. In fact, JGB yields did not go up, they continued to trend down. As feeble yields became even feebler, the owners of the short positions got carried out of their careers, feet first. Meanwhile, those investors who owned 30-year JGBs yielding a ‘feeble’ 2 percent in 2013 reaped returns of 75 percent, and even now, are sitting on handsome profits of 55 percent. Some people protest that Japan is an exceptional and isolated case, rather than a template for economies which will not repeat their putative policy-errors. Such protests have always struck us as factually wrong, blinkered, and even prejudiced. Nevertheless, let’s indulge these prejudices with a simple rejoinder – forget Japan, what about Switzerland, or the UK? (Chart I-6) Chart I-6Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Meanwhile, those investors who owned 30-year UK gilts yielding a ‘feeble’ 2 percent in 2018 reaped returns of 40 percent, and even now are sitting on tidy profits of 30 percent. Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Bear in mind that a 30-year bond yielding a feeble 2 percent will deliver a cumulative return of more than 80 percent to redemption. And that if the feeble yield becomes even feebler, this return will get front-end loaded, creating widow makers for the short positions and spectacular gains for the long positions, as witnessed in JGBs and UK gilts. The 30-Year T-Bond Is A Must-Own Structural Investment The next candidate for the widow maker is shorting the US 30-year T-bond, which is yielding, you guessed it, 2 percent. Remember that while Japan may not be a great template for the US, the UK certainly is – because the US and UK have very similar economic, financial, political, social, and cultural structures. Until recently therefore, bond yields in the US and UK were moving in near-perfect lockstep (Chart I-7). Chart I-7The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock So, what happened? The one word answer is: Brexit. The recent difference between US and UK bond yields is simply that the UK has had one more deflationary shock than the US. Put the other way around, the US is just one deflationary shock away from a UK level of bond yields – meaning the 30-year yield not at 2 percent, but at 1 percent. But why can’t the next shock be an inflationary shock resulting in much higher yields? The simple answer is that the equity risk premium has turned negative for the first time since 2002. Moreover, as we pointed out in The Road To Inflation Ends At Deflation the extremely rich valuation of $300 trillion of global real estate is also highly contingent on ultra-low bond yields. It follows that any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. In a $90 trillion global economy, this will quickly flip any incipient inflationary shock into a deflationary shock. Any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. We conclude that the US 30-year T-bond is a must-own structural investment. Fractal Analysis Update As hospitals have rushed to clear their backlog of non-pandemic treatments and procedures, medical equipment stock prices have surged. This is particularly true for US medical equipment (ticker IHI) which, since June, is up by 25 percent versus US healthcare services (Iqvia, Veeva, or loosely proxied by ticker XHS). Given that the backlog of treatments will eventually clear, and that the intense rally is now extremely fragile on its 65-day fractal structure (Chart I-8), a recommended countertrend trade is to short US medical equipment versus healthcare services. Set the profit target and symmetrical stop-loss at 8.5 percent.  Chart I-8The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile The Intense Rally In Medical Equipment Stocks Has Become Fragile   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   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  

Highlights Chart 1Employment Growth Will Rebound Employment Growth Will Rebound Employment Growth Will Rebound August’s weak employment growth reflects the surge of Delta variant COVID cases in the United States. This is evidenced by the fact that Leisure & Hospitality sector payrolls held flat in August after having grown by 415k in July and 397k in June (Chart 1). While Delta could still be a drag on employment growth for another month or two, there is mounting evidence that the daily new case count is close to its peak. Leisure & Hospitality employment growth will regain its prior pace as new Delta cases trend down. This will lead to a resumption of strong monthly payroll reports (500k – 1000k) as we head into the new year. For monetary policy, we calculate that average monthly nonfarm payroll growth of 414k will be sufficient for the Fed to start rate hikes before the end of 2022 (bottom panel). We anticipate that this threshold will easily be met. The Treasury curve will bear-flatten as employment growth improves and the market prices-in an earlier start and quicker pace of Fed rate hikes. Investors should maintain below-benchmark portfolio duration and stay short the 5-year Treasury note versus a duration-matched 2/10 barbell. Feature Table 1Recommended Portfolio Specification The Delta Drag The Delta Drag Table 2Fixed Income Sector Performance The Delta Drag The Delta Drag Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 5 basis points in August, dragging year-to-date excess returns down to +166 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 91 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled for corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated Emerging Market sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Delta Drag The Delta Drag Table 3BCorporate Sector Risk Vs. Reward* The Delta Drag The Delta Drag High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in August, bringing year-to-date excess returns up to +502 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.0% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first seven months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in August, dragging year-to-date excess returns down to -67 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 4 bps in August. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 2 bps in August (panel 2), and it is now starting to look attractive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 38 bps, below the 56 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 35 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to +84 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 122 bps in August, bringing year-to-date excess returns up to +7 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +44 bps. Local Authority bonds outperformed by 9 bps in August, bringing year-to-date excess returns up to +382 bps. Domestic Agency bonds outperformed by 3 bps, bringing year-to-date excess returns up to +30 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to +31 bps. USD-denominated Emerging Market (EM) Sovereign bonds outperformed US corporates in August and relative valuation between the two sectors is starting to equalize (panel 4). That said, we retain a preference for EM sovereigns over US corporates, particularly the bonds of Russia, Mexico, Saudi Arabia, UAE and Qatar where value remains attractive. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 9 basis points in August, dragging year-to-date excess returns down to +262 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 5% breakeven tax rate versus corporates with the same credit rating and duration. 12-17 year Revenue munis actually offer a before-tax yield pick-up (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 23% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved higher in August, with the 5-year and 7-year maturities bearing the brunt of the sell-off. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 110 bps. The 5-year/30-year slope flattened 5 bps to end the month at 115 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 1.93%, the 5-year/5-year forward Treasury yield is not that far below our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.21% in one year’s time and 1.47% in five years (Chart 7). The latter rate has 146 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 265 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.  TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in August, leaving year-to-date excess returns unchanged at +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell by 7 bps in August. At 2.37%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.21%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation continues to moderate from its current extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in August, bringing year-to-date excess returns up to +40 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +30 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +92 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in August, bringing year-to-date excess returns up to +193 bps. Aaa Non-Agency CMBS outperformed Treasuries by 10 bps in August, bringing year-to-date excess returns up to +92 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 9 bps on the month, dragging year-to-date excess returns down to +529 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in August, bringing year-to-date excess returns up to +91 bps. The average index option-adjusted spread held flat on the month. It currently sits at 35 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of August 31st, 2021) The Delta Drag The Delta Drag Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of August 31st, 2021) The Delta Drag The Delta Drag Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 12 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 12 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Delta Drag The Delta Drag Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of August 31st, 2021) The Delta Drag The Delta Drag Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Highlights A trio of ECB hawks raised the prospect of an ECB taper. In the past, the current set of economic conditions in the Euro Area would have prompted the ECB to tighten policy. A potential economic deceleration this fall, the transitory nature of the Eurozone’s inflation spike, and the level of inflation expectation in the region limit the ECB’s ability to taper this week. We expect a one-off return to the pre-Q2 2021 level of asset purchases couched in a very dovish forward guidance. Peripheral bonds and European corporate bonds will outperform German and other core European paper. Stay long European curve steepeners, while buying US curve flatteners. Overweight German Bunds versus US Treasury Notes, on a USD-hedged basis. European productivity will remain structurally hampered compared to that of the US. US real bond yields will rise relative to Europe. Feature Last week, a chorus of ECB Governing Council members raised the idea among investors that the central bank may soon begin to taper its asset purchases, which prompted Bund yields to hit -0.35% on Wednesday. Robert Holzmann of Austria, Klaas Knot of the Netherlands, and Jens Weidmann of Germany all suggested that monetary conditions were too accommodative for the Eurozone and that the ECB needed to remedy this problem. The complaints of this hawkish trio reflect the current environment. In August, the Eurozone HICP reached a 3% annual rate while the preliminary estimate for core CPI clicked in at 1.6%. Meanwhile, July PPI rose to 12.1%. Such robust inflation readings are at odds with the low level of interest rates in the Eurozone, where the yields on European IG credit and 10-year Italian BTPs average a paltry 0.45% (Chart 1). Beyond the level of inflation, its broad geographic nature is an additional source of concern. Headline CPI is accelerating across all the bloc’s nations, and it stands above 2% in 82% of the members’ states. Historically, this kind of inflationary backdrop resulted in either higher interest rates or some tapering of asset purchases, especially when economic activity was also improving in the Eurozone (Chart 2). Chart 1A Gap For The Hawks A Gap For The Hawks A Gap For The Hawks Chart 2In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened Will the ECB listen to its most hawkish members and follow its past script? We do not believe that the Governing Council is about to start a sustained period of decreased bond buying, even if a return to the pre-Q2 2021 pace of buying is likely this fall. Thus, a dovish taper is the most likely outcome of this week’s meeting. The ECB’s Three Constraints The outlook for growth, the temporary nature of the current spike in European inflation, and the low-level of Euro Area inflation expectations limit the ECB’s ability to remove monetary accommodation. First, European economic growth is at its apex and will decelerate over the next six months. Currently, domestic activity as approximated by the Services PMI stands at near a 15-year high of almost 60. Moreover, despite the spike in COVD-19 cases linked to the Delta variant, mobility remains very robust. If anything, the decline in cases in Spain and France should lead to further improvement in mobility (Chart 3). Nonetheless, the recent fall in consumer confidence and the recent US experience, which the European economy usually follows, point to a deceleration in the Services PMI. The case for a decline in manufacturing activity is more pronounced. The European manufacturing sector responds strongly to the fluctuation of the global industrial sector. US consumer spending on durable goods is 21% above its pre-pandemic trend and is beginning to weaken as pent-up demand for such products has been satiated and households shift their spending back toward services. Moreover, the Chinese credit cycle, which leads the Eurozone Manufacturing PMI by nine months, indicates a greater deceleration in the coming quarters, because European exports to China will slow (Chart 4, top and middle panels). In response to these two forces, Europe will not diverge from the deterioration in our Global Activity Nowcast (Chart 4, bottom panel). Chart 3So Far, No Delta Impact So Far, No Delta Impact So Far, No Delta Impact Chart 4The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown Chart 5Abnormal Goods Inflation Abnormal Goods Inflation Abnormal Goods Inflation Second, most evidence still suggests that the current inflation increase will be temporary, despite its violence. To begin with, the spike in inflation remains consigned to the goods sectors, while services inflation stands at 1.1%, in line with the experience of the past 10 years (Chart 5). Even within goods prices, the spike in CPI is limited to sectors facing bottlenecks or linked closely to commodity and shipping prices. As Chart 6 illustrates, the categories experiencing abnormal inflation are directly related to higher energy prices, cars, complex machinery, hotels, and fresh food. Meanwhile, underlying inflation as estimated by our trimmed-mean CPI measure is bottoming, but remains at a very low 0.2% annual rate (Chart 7). Chart 6Inflation Remains A Commodity and Bottleneck Story The ECB Taper Dilemma The ECB Taper Dilemma In the same vein, the surge in Selling Price Expectations of the European Commission Business Survey is a function of commodity inflation (Chart 8). In other words, companies feel they can increase their selling prices, because natural resource prices have spiked. However, inflation across many commodities is currently peaking, which suggests that Selling Price Expectations will soon do so as well. Moreover, this process indicates that headline inflation should hit its summit by year end, because Selling Price Expectations are a coincident indicator of inflation (Chart 8, bottom panel). Chart 7Narrow Inflation Narrow Inflation Narrow Inflation Chart 8Rising Selling Prices And Commodities Rising Selling Prices And Commodities Rising Selling Prices And Commodities A wage-inflation spiral also remains far away. Historically, rapidly accelerating wage growth marked periods of elevated inflation. Despite current fears, such a development is not taking place in the Eurozone. For the whole bloc, negotiated wages are growing at a modest 1.7% annual rate (Chart 9). Even in Germany, negotiated wages are only increasing at the same rate. While some labor shortages have been reported, total hours worked remain below the equilibrium level based on the Euro Area demographic profile (Chart 9, bottom panel). Furthermore, the past ten years reveal that labor shortages only caused stronger salary growth with a multi-year delay. Third, the market doubts the credibility of the ECB when it comes to achieving a 2% inflation target. So far, survey-based inflation expectations remain below 2% at all tenors (Chart 10, top panel). The same is true of market-based measures, which are still lower than the levels that prevailed before the sovereign debt crisis of the past decade (Chart 10, bottom panel). Chart 9No Wages/Inflation Spiral No Wages/Inflation Spiral No Wages/Inflation Spiral Chart 10The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible Bottom Line: Risks to growth over the winter, the transitory nature of the recent inflation shock, and inflation expectations that remain significantly below target are constraints limitating the ability of the ECB to announce a true tapering of its asset purchases this Thursday. A Dovish Taper? Considering the current set of conditions prevailing in the Eurozone, we expect the ECB to announce a return to the pace of asset purchases that existed prior to Q2 2021. However, the Governing Council (GC) will go out of its way to issue clear forward guidance that strongly indicates this is not the beginning of a taper campaign. Instead, the GC will hint at the transmutation of a large proportion of the PEPP monthly buying into the PSPP after March 2022. The inflation target change enacted at the conclusion of the ECB’s strategy review in July limits the central bank’s ability to go back to its old rule book and tighten policy at the first hint of inflation. First, the ECB must believe that inflation will overshoot 2% on a durable basis, which will necessitate an upgrade to its long-term inflation forecast above the target. Too many members of the GC do not share this view, which makes it unlikely that inflation forecasts will rise this much this week. Moreover, inflation expectations are also too low to warn of a meaningful change in the behavior of European economic agents, especially if the current spike in inflation proves to be transitory. Another problem for the ECB is the Fed. If the ECB were to announce a durable tapering of its asset purchase this week, it would be doing so ahead of the Fed. The GC fears that this action would put considerable upward pressure on EUR/USD, which would create a grave deflationary tendency in the Eurozone (Chart 11). Despite these shackles, the ECB will also acknowledge that the current emergency pace of asset purchases is no longer warranted. Starting Q2 2021, the ECB increased its average monthly purchase from EUR80 billion in the August 2020 to March 2021 period, to EUR95 billion since April 2021 (Chart 12). However, these increased purchases followed a 0.1% GDP contraction in Q1 in the wake of a spike in COVID-19 cases and deaths, which prompted a large reduction in mobility. Moreover, the larger bond buying also followed large increases in bond yields across the main economies of the continent, a rise which, if it had been left unchecked, would have exacerbated the economic malaise. Chart 11The ECB Fears A Strong Euro The ECB Fears A Strong Euro The ECB Fears A Strong Euro Chart 12Normalizing Purchases The ECB Taper Dilemma The ECB Taper Dilemma None of these factors are still present. The increasing level of vaccination has dulled the economic impact of the third wave of infection. The economy is expanding robustly and, even if it slows in the months ahead, growth will remain well above trend. Crucially, financial conditions are much more generous than in the first half of the year, with a euro that trades 4% below its January peak and with yields in the bloc’s four largest economies 25 to 45 basis points below their spring peaks. Bottom Line: In response to the aforementioned crosscurrents, we anticipate the ECB to announce a return of its monthly asset purchases to the level that prevailed in the August 2020 to March 2021 period. However, the GC will also clearly indicate, as it did last March, that this policy shift is a one-off, and that investors must not anticipate any further curtailment of asset purchases over the next six months. To reinforce this guidance, we expect the ECB’s inflation forecast to show a return of HICP below 2% by the end of 2023. The GC might also hint at the roll-over of the PEPP program into the PSPP after March 2022. Investment Implications An ECB that conducts a dovish taper on Thursday will support our main fixed-income themes in Europe. First, it will remain a tailwind behind an overweight position in peripheral government bonds versus German bonds. The combination of continued purchases of EUR80 billion a month of bonds over the foreseeable future, above-trend growth, and the fiscal risk mutualization from the NGEU and REACT EU programs means that investors can continue to safely pocket the yield premium offered by BTPs and BONOs. Moreover, our geopolitical strategists expect a left-wing coalition to govern Germany after the September 26 election, which will limit the pressures to tighten budgets in the periphery over the coming years. Chart 13European Corporates Remain Attractive European Corporates Remain Attractive European Corporates Remain Attractive Second, continued liquidity injections by the ECB are also consistent with a preference for European corporate credit over government securities, especially in Germany, France, and the Netherlands. European breakeven spreads for IG and high-yield debts are in the 18th and 13th percentile rank, respectively (Chart 13). Easy monetary conditions and above-trend growth will facilitate further yield-seeking behavior in the Eurozone. This process will allow these securities to offer continued excess returns over at least the next six months. Third, we hold on to our box trade of being long Eurozone curve steepeners and long US curve flatteners. In our base case scenario, the Fed will soon indicate the beginning of its tapering campaign and will be on track to raise rates by early 2023, while the ECB will still conduct a very easy monetary policy. In this context, the US yield curve will flatten relative to the European one, driven by a more rapid increase at the short end of the curve. Chart 14Still Favor Bunds Over T-Notes The ECB Taper Dilemma The ECB Taper Dilemma Finally, in a global bond portfolio, it still makes sense to overweight German Bunds (hedged into USD) relative to US Treasury Notes. Bunds display a significantly lower yield beta than their US counterparts, which creates an attractive defensive feature in an environment in which global yields are likely to rise. Moreover, as the model in Chart 14 highlights, the US/German 10-year yield spread is roughly 50bps below an equilibrium estimate based on relative inflation, unemployment and policy rates, and the size of the Fed and ECB balance sheets. US inflation is likely to remain perkier than that of Europe over the coming quarters, and the US unemployment rate will decline faster as well. Additionally, in the unlikely scenario that the Fed declines to taper its purchases this year, but the ECB does, inflation expectations will rise in the US relative to the Euro Area, which will put upward pressure on yield spreads. Bottom Line: A dovish ECB taper, whereby the GC executes a one-off adjustment in asset purchases with an easy forward guidance, will support our overweight in peripheral government bonds relative to bunds, our preference for European corporate credit relative to government paper, our Europe / US box trade, and BCA’s underweight in Treasurys relative to Bunds. Europe’s Productivity Deficit Is Not Over Compared to the US, GDP growth in the Eurozone has been trending lower since the introduction of the euro in 1999. While a weaker demographic profile has hurt Europe, so has slower productivity growth. Going forward, the gap between European and US productivity growth will somewhat narrow compared to last decade, but it will still favor the US. The cross-Atlantic gap in output per hour growth between has a cyclical and a structural component. The cyclical element is set to ebb. Last decade, the Eurozone suffered a double-dip recession, as the European sovereign debt crisis raged. As a result, capex and debt accumulation in Europe lagged that of the US, which hurt demand and, thus, output-per-hour worked (Chart 15, top panel). Going forward, the European debt crisis has been addressed, the ECB has demonstrated its willingness to do “whatever it takes” to support the monetary union and both the European Commission and the German government have thrown their full weight behind the integrity of Europe, even if it means bailing out their profligate southern neighbors. Despite this positive, some structural headwinds will continue to handicap European productivity. Since 2000, total factor productivity in the major Euro Area economies has lagged that of the US (Chart 15, bottom panel). Many factors suggest this will not change: Chart 15Europe’s Productivity Deficit The ECB Taper Dilemma The ECB Taper Dilemma The Eurozone’s big four economies continue to linger well behind the US in terms of ICT investment, which in recent decades has been a crucial driver of productivity. R&D represents a significantly lower share of GDP in the Eurozone than it does in the US (Chart 16). More investment in intangible assets has been linked to higher productivity growth. Additionally, Ortega-Argilés et al. have shown that EU companies do not convert R&D into productivity gains as well as US businesses do, because they generate lower return on investments.1 Confirming this insight, an empirical study using microdata on R&D spending for EU and US firms highlights that both R&D intensity and productivity are lower for EU firms than for their US counterparts.2 For a 10% increase in R&D intensity, US businesses generated a 2.7% increase in productivity, while EU firms enjoyed a much smaller 1% gain. The gap is larger for high-tech companies, where the same rise in R&D intensity produced a 3.3% productivity gain in the US, but only a 1.2% one in the EU. The European economy remains much more fragmented than that of the US, and the greater prevalence of small firms in the Euro Area results in a less efficient use of the human and capital stocks. Finally, the low rate of investments in recent years has caused the European capital stock to age faster than that of the US. An older pool of assets is further away from the technological frontier and thus weighs on TFP and overall labor productivity (Chart 17). Chart 16Lagging European R&D The ECB Taper Dilemma The ECB Taper Dilemma Chart 17The Ageing European Capital Stock The Ageing European Capital Stock The Ageing European Capital Stock Notwithstanding cyclical fluctuations related to the global debt cycle, the Eurozone profit margins and RoEs will not converge meaningfully toward US levels on a structural basis because of this productivity problem. Europe’s lower industry concentration ratios, lower markups, and greater share of output absorbed by wages will only accentuate this problem. Chart 18TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds As a result of the lower trend growth rate caused by lower productivity and its inferior return on invested capital, Europe’s R-Star is unlikely to catch up meaningfully to US levels. Consequently, the gap between US and Germany real rates will remain wide and will drive the increase in US yields relative to those of Germany, as the Fed begins to tighten policy while the ECB stands pat (Chart 18). Bottom Line: Europe’s productivity deficit is not the only consequence of last decade’s sovereign debt crisis. Thus, the Euro Area’s potential GDP growth and return on invested capital will lingers behind those of the US. As a corollary, the Eurozone’s R-star is well below that of the US. Hence, we expect higher real rates to drive the increase in US yields over Germany as the Fed tightens policy ahead of the ECB.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1R. Ortega-Argilés, M. Piva, and M. Vivarelli, “The Transatlantic Productivity Gap: Is R&D the Main Culprit?,” Canadian Journal of Economics 47.4 (2014), pp. 1342-71. 2D. Castellani, M. Piva, T. Schubert, and M. Vivarelli, “The Productivity Impact of R&D Investment: A Comparison between the EU and the US,” IZA Discussion Papers 9937 (2016). Tactical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Cyclical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Structural Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Closed Trades The ECB Taper Dilemma The ECB Taper Dilemma Currency Performance Fixed Income Performance Equity Performance

Highlights Jackson Hole: The message from Jackson Hole is that the majority of the FOMC – including Fed Chair Powell - is ready to begin tapering asset purchases before year-end. There is less unanimity within the FOMC over the timing of interest rate increases following the taper. Fed Policy: The Fed is trying to communicate a separation of the balance sheet and interest rate components of its monetary policy, hoping to limit bond volatility stemming from markets pulling forward the timing of rate hikes during the taper. A tightening US labor market will make that separation difficult given the shallow path for interest rates currently discounted in the US yield curve - particularly if the current surge in US inflation proves not to be as transitory as the Fed is expecting. US Treasury Yields: Expect higher Treasury yields over the next 12-18 months as the Fed transitions from talking about tapering to actual tapering and, eventually, to rate hikes starting in H2/2022. A September To Remember? Chart 1The Fed Faces Some Tough Decisions The Fed Faces Some Tough Decisions The Fed Faces Some Tough Decisions The much anticipated Jackson Hole speech from Fed Chair Jerome Powell offered a balanced tone.1 Powell did say that the Fed could begin tapering asset purchases by the end of this year, given the “substantial further progress” on the Fed’s 2% average inflation goal, if the US economy evolved in line with the Fed’s forecasts. However, Powell also noted that rate hikes would not occur without greater improvements in the US labor market, particularly given the Fed’s view that the current surge in US inflation will not prove lasting. Several other Fed officials speaking to the media before Powell’s speech hinted at a much more accelerated timetable, with tapering to begin in September and rate hikes potentially starting as soon as mid-2022. The Fed’s messaging is part of an extended conversation with financial markets to prepare for a withdrawal of pandemic-era policy stimulus from quantitative easing (QE). The FOMC is well aware that valuations on asset prices of all stripes have been boosted by loose monetary settings. Powell’s Jackson Hole comments were more nuanced than those of his FOMC colleagues, but this is no surprise as the words of the Fed Chair carry the greatest weight among investors. The Fed Chair does not want to risk a repeat of the 2013 Taper Tantrum in Treasury yields, or the December 2018 plunge in US equity prices, by sounding unexpectedly hawkish and triggering a market rout that tightens US financial conditions (Chart 1). Our baseline assumption has been that the Fed would signal a tapering at the December FOMC meeting and begin to slow asset purchases in January 2022, leading to an eventual liftoff of the fed funds rate by the end of next year. The comments from Powell and others have raised the risk that the Fed moves a bit faster than our expectations on tapering, and perhaps even for liftoff (Chart 2). This would also be faster than the expectations among bond investors. Chart 2The Fed May Be Set To Move Faster Than Our Expected Timeline The Fed’s Separation Anxiety The Fed’s Separation Anxiety The New York Fed’s Survey of Primary Dealers in July showed that tapering is expected by Q1 of next year but a rate hike was not projected until the latter half of 2023 (Table 1). Current pricing in the US overnight index swap (OIS) forward curve is a bit more hawkish than that, with a full 25bp rate hike discounted by January 2023. Table 1Primary Dealers Expect A Taper, Not Rate Hikes The Fed’s Separation Anxiety The Fed’s Separation Anxiety The Fed’s next move will depend on how the questions regarding the Delta variant, the true state of the US labor market and underlying US inflation momentum are resolved. Dismissing The Delta Threat? There has been a clear hit to US economic confidence from the spread of the variant. The August readings from the University of Michigan consumer sentiment survey, the Philadelphia Fed business outlook survey and the ZEW survey of US growth expectations all showed sharp declines (Chart 3). The August flash estimate of the Markit PMIs fell to 8-month and 4-month lows, respectively, indicating that the pace of US economic activity slowed. Higher frequency data like restaurant reservations and hotel bookings have also dipped in recent weeks, potentially a sign of US consumers turning more cautious on leaving home during the Delta surge. Yet there is some tentative positive news on the spread of the variant. The 7-day moving average of new COVID-19 cases in the US appears to be rolling over (Chart 4). In the more stricken states in the US south like Florida, Texas and Louisiana, the effective reproduction number has fallen below one and cases are clearly peaking, suggesting that the transmission of Delta is slowing. If these trends continue, the full hit to US growth from the variant could prove to be minimal and potentially contained to only August data Chart 3A Hit To US Confidence From The Delta Variant A Hit To US Confidence From The Delta Variant A Hit To US Confidence From The Delta Variant Chart 4Has The US Delta Wave ##br##Peaked? Has The US Delta Wave Peaked? Has The US Delta Wave Peaked? Fed officials have been highlighting Delta as a potential near-term risk to the economy, but some comments made last week suggested only a modest level of concern that would not derail tapering plans. For example: Dallas Fed President Robert Kaplan: “[…] what I'm seeing is, in certain sectors, as you would expect, travel-related, you're seeing weakness in some other sectors but by and large, predominantly, what we're seeing is resilience across the indicators that we look at.”2 Kansas City Fed President Esther George: “[…] by and large, I think, unlike what we experienced last year, people have mechanisms to continue to interact with the economy in a way that we didn't before. And so that gives me some confidence in the outlook that we see, that we could continue to push through this.”3 Atlanta Fed President Raphael Bostic: “What I have seen is some suggestion that things are slowing down, but they are still just slowing from extremely high levels. I have not seen big changes in the underlying dynamic.”4 Even Powell himself noted in his speech that “while the Delta variant presents a near-term risk, the prospects are good for continued progress toward maximum employment.” If the hit to the domestic US economy from Delta proves to be modest and short-lived, the Fed will want to see confirmation of this in the US employment data. Labor market slack overestimated? It is clear from other comments made last week that FOMC officials will be watching the August payrolls report very closely, especially given the perception that the US job market may be a lot tighter than the headline unemployment rate suggests. For example, Fed Governor Christopher Waller noted that “when you adjust the labor force for early retirements, if we get another million [jobs in August] we will recover about 85% of the jobs that were lost and that took almost seven years after the last recession.”5 Kaplan noted that “we do think that the labor market is much tighter than the headline statistics indicate. We've had 3 million retirements since February 2020.” Our colleagues at BCA Research’s The Bank Credit Analyst came to a similar conclusion on labor market tightness in a report published last week.6 They determined that the single largest factor driving the US labor force participation rate lower since the onset of the pandemic has been individuals choosing to retire (Chart 5). Only some of that decline has been related to early retirement decisions made in response to COVID. There has been a structural trend of a falling participation rate, by an average of 0.3 percentage points per year, since 2008 due to demographic factors. The labor force participation rate does not need to fully return to pre-pandemic levels for the Fed to conclude that its maximum employment goal has been reached, after accounting for retirements and other demographic shifts (Chart 6). This fits with the comments from Waller and Kaplan indicating that there has likely been enough labor market improvement to begin tapering asset purchases. Chart 5Most Of The Pandemic Decline In Labor Force Participation Has Occurred Due To Retirement The Fed’s Separation Anxiety The Fed’s Separation Anxiety Chart 6Full Employment Without A Pre-COVID Participation Rate Full Employment Without A Pre-COVID Participation Rate Full Employment Without A Pre-COVID Participation Rate Transitory or persistent inflation? In his Jackson Hole speech, Fed Chair Powell downplayed many of the factors that have driven US headline inflation higher in 2021 as “[…] the product of a relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy.” He also noted that the current surge in durable goods inflation, which has contributed “about one percentage point to the 12-month measures of headline and core inflation”, was likely to end once current supply chain disruptions fade. Durables would then return to the deflationary trend of the past 25 years and help cool off current overheated US inflation. Chart 7US Inflation Is Not Slowing Down US Inflation Is Not Slowing Down US Inflation Is Not Slowing Down Powell also noted the absence of significant US wage growth as reason not to be overly worried about a sustained period of high inflation. He also highlighted that “there is little reason to think” that ongoing structural disinflationary forces like technology and globalization “have suddenly reversed or abated” and that “it seems more likely that they will continue to weigh on inflation as the pandemic passes into history.” This is the message that the Fed has consistently communicated over the past several months, that high inflation was merely “transitory” and the inevitable result of year-over-year base effect comparisons and temporary supply squeezes. The problem with this interpretation is that we are now well into the summer months of 2021, past the period where base effects would be expected to boost US year-over-year inflation rates (the level of both the CPI and PCE deflator indices fell between January and May 2020 before starting to climb again in June). The July 2021 readings on annual headline and core PCE inflation were 4.2% and 3.6%, respectively, the highest rates seen since 1991 (Chart 7, top panel). The year-over-year increase appears to have been concentrated in a few components, with the Dallas Fed’s trimmed mean PCE 12-month inflation for July only climbing to 2.0%. However, the 6-month annualized measure was a more rapid 2.6% - the fastest such pace in 13 years - suggesting that the momentum of US inflation is both broadening and accelerating on the margin (second panel). Chart 8A Sustainable, Not Transitory, Rise In Global Inflation A Sustainable, Not Transitory, Rise In Global Inflation A Sustainable, Not Transitory, Rise In Global Inflation Powell, like many other developed market central bankers, is making a big bet that the “transitory” inflation narrative will prove to be correct and the current surge in inflation will soon subside. Yet already, global supply chain disruptions have lingered longer than the Fed has been expecting. There are also deeper underlying trends in inflation that are challenging the “transitory” narrative. The NFIB small business survey showed that a net 52% of respondents reported raising selling prices in July, while a net 44% planned future price hikes (third panel), both readings last seen during the days of double-digit US inflation in the late 1970s. US firms are successfully passing on rising input costs to US consumers, which is influencing US consumer inflation expectations. The University of Michigan consumer survey for August showed that US households expect inflation over the next year of 4.6% and over the next 5-10 years of 2.9%, with both series well above pre-pandemic lows (bottom panel). The trends in higher inflation seen in the US, and elsewhere, are not just limited to commodity prices where supply squeezes were most prevalent earlier this year and where price momentum is peaking (Chart 8). A GDP-weighted average of core inflation rates for 14 developed market economies reached 2.50% in June and 2.4% in July, levels last seen in the mid-1990s. Higher core inflation readings are consistent with intensifying price pressures stemming from diminished economic slack. The broad swings in our global core inflation measure correlate strongly with the IMF’s estimate of the output gap for the advanced economies (bottom panel). The current acceleration in global core inflation is entirely consistent with the rapid narrowing of the global output gap projected by the IMF for 2021 and, more importantly, 2022. This suggests that underlying inflation pressures, both within and outside the US, will linger into next year, providing an offset the expected drag on “non-core” inflation from slowing commodity price momentum. Already, lingering supply squeezes and stubbornly high US inflation are causing concern among some FOMC members, as noted in these comments last week: Robert Kaplan: “[…] headline PCE inflation next year, we think is going to be in the neighborhood of 2.5%, and there's risk that could be higher. And so we think some of these supply-demand imbalances for materials, some of them will not moderate, but some of them are going to persist longer than people think.” Esther George: “[…] if you continue to have supply constraints and strong demand, you might expect that those will persist more through this year or longer than we originally anticipated.” Chris Waller: “I do think it’s going to be more persistent than I may have thought back in May.” Chart 9Fed Tapering To Deal With Financial Stability Risks? Fed Tapering To Deal With Financial Stability Risks? Fed Tapering To Deal With Financial Stability Risks? Importantly, the senior FOMC leadership - Powell, Lael Brainard, Richard Clarida – has been sticking with the “transitory” narrative. However, even Clarida noted in a speech in early August that he would consider core PCE inflation at or above 3% at year-end to be “much more than a “moderate” overshoot” of the Fed’s 2% inflation objective.7 In his role as Fed Chair, Powell must speak on behalf of the entire FOMC, even if those views are not necessarily his own. Given the growing chorus of Fed voices expressing concern that US inflation could remain higher for longer, it will be increasingly difficult for Powell to do what he did at Jackson Hole – sound more dovish than the individual FOMC members with regards to inflation risks. What about financial stability risks from QE? Fed officials have been understandably cautious in their comments about how QE (and a 0% funds rate) could be influencing asset prices (Chart 9). However, with equity markets at record highs, corporate bond yields near record lows despite high levels of corporate leverage, and US house prices soaring – the S&P CoreLogic Case-Shiller national index rose 18.6% on a year-over-year basis in June, the fastest pace in its 35-year history - it is difficult not to see the role of the Fed’s easy money policies in boosting risk seeking, yield chasing activities. Stimulative financial conditions are also creating future upside growth risks, with the Conference Board leading economic indicator now reaccelerating (bottom panel). Robert Kaplan, Boston Fed President Eric Rosengren and St. Louis Fed President James Bullard have voiced concerns that QE, particularly the Fed’s buying of agency mortgage-backed securities (MBS), have played a significant role in the current US housing boom. The senior FOMC leadership has avoided any such comments for obvious reasons – imagine the market reaction if Powell expressed concerns about high house prices or equity market valuations. However, for those at the Fed already looking to begin tapering sooner, booming asset prices are an additional reason to vote that way as soon as the September FOMC meeting. Separating Tapering From Rate Hikes It seems clear that the majority of the FOMC is now leaning towards starting to taper before year-end, if US growth and employment maintain recent strength. The common message of Fed officials, from Powell on down, is that enough progress has been made on the Fed’s 2% average inflation target objective to justify tapering. Market-based inflation expectations from the TIPS and CPI swap markets are consistent with that interpretation, with breakevens and forward inflation rates within the 2.3-2.5% range consistent with the Fed’s 2% inflation mandate (Chart 10). Yet while our Fed Monitor continues to flag the need for tighter US monetary policy, only 100bps of rate hikes are discounted in the US OIS curve by the end of 2024 – and only after a first rate hike not expected to occur until January 2023. Despite the common messaging on the start of the taper, the Fed voices were singing a bit less in harmony about the potential timing of the first interest rate hike post-taper. Powell went out of his way to note in his Jackson Hole speech that “the timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.” That test, of course, is when the Fed deems that its maximum employment objective has been reached. Can the Fed continue to successfully separate guidance on balance sheet decisions from guidance on future interest rate moves? Current pricing from US OIS and CPI swap forward curves indicates that the market is discounting negative real policy rates, with the Fed never raising rates above inflation, for the next decade (Chart 11). This goes a long way to explain the persistence of negative real US Treasury yields at a time of elevated inflation readings. Although a decade of negative real interest rates is also consistent with the market believing the equilibrium real interest rate (i.e. r-star) is negative – a view currently expressed by no one on the FOMC. Chart 10Too Few Rate Hikes Discounted In The US OIS Curve Too Few Rate Hikes Discounted In The US OIS Curve Too Few Rate Hikes Discounted In The US OIS Curve Chart 11Markets Believe The Fed Will Never Raise Rates Above Inflation Markets Believe The Fed Will Never Raise Rates Above Inflation Markets Believe The Fed Will Never Raise Rates Above Inflation That persistent pricing of negative real rates make sense when there is modest headline inflation and ample spare capacity in the US economy and labor markets. However, that complacency on future rate hikes will be shaken if the US economy approaches full employment and inflation remains above the Fed’s 2% target – outcomes that we expect to occur by the second half of next year. That will lead to the first fed rate hike of the next cycle in Q4 2022, but only after the taper that we expect to start in either December 2021 or January 2022 is completed in Q3 2022. Bottom Line: A tightening US labor market will make the Fed’s current guidance on the separation of tapering from rate hikes increasingly unconvincing, given the shallow path for interest rates currently discounted in the US yield curve - particularly if the current surge in US inflation proves not to be as transitory as the Fed is expecting. Jackson Hole Investment Conclusion – Expect Higher US Treasury Yields Chart 12Stay Below-Benchmark On US Duration Stay Below-Benchmark On US Duration Stay Below-Benchmark On US Duration With such a modest path for future rate hikes, and bond yields, discounted in US forward interest rate curves, we continue to advocate positioning for higher US Treasury yields on a strategic (6-18 months) basis (Chart 12). We see the benchmark 10-year Treasury yield eventually reaching a peak in the 2-2.25% range by the end of 2022. We recommend maintaining a below-benchmark duration stance in the US, while staying underweight US Treasuries in US and global bond portfolios. There is even a case to be made for a more tactical (i.e. shorter-term) bearish stance on US Treasuries with the US data surprise cycle set to turn towards upside surprises, especially if the negative impact of the Delta variant on confidence and spending begins to wane as case numbers start to decline in the coming weeks. Bottom Line: Expect higher Treasury yields over the next 12-18 months as the Fed transitions from talking about tapering to actual tapering and, eventually, to rate hikes starting in H2/2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 A transcript of Powell’s speech can be found here: https://www.federalreserve.gov/newsevents/speech/powell20210827a.htm 2 https://finance.yahoo.com/news/dallas-fed-president-robert-kaplan-yahoo-finance-transcript-august-2021-215700082.html 3 https://finance.yahoo.com/news/kansas-city-fed-president-esther-george-yahoo-finance-transcript-august-2021-113024734.html 4 https://www.reuters.com/business/exclusive-feds-bostic-says-reasonable-begin-bond-buying-taper-october-2021-08-27/ 5 https://finance.yahoo.com/news/fed-gov-waller-strong-august-jobs-report-will-be-green-light-for-taper-202340105.html 6 Please see BCA Research The Bank Credit Analyst September 2021 Section II, “The Return To Maximum Employment: It May Be Faster Than You Think”, available at bca.bcaresearch.com 7 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommendations Duration Regional Allocation Spread Product Yields & Returns Global Bond Yields Historical Returns

Highlights We are reviewing our recommendations. We are also introducing recommendation tables to monitor these positions. Overall, our main recommendations have generated alpha and have a positive batting average. Feature The end of the month of August offers an opportunity to review the positions recommended in this publication. We introduce three tables corresponding to three investment horizons—tactical, cyclical, and structural—which summarize our main views. Each table is subdivided by asset class, namely equities, fixed income, and currencies. The tables can be found on page 12 and 13 and will be available at the end of future strategy reports. Tactical Recommendations Short Equity Leaders / Long Laggards This position is down 1.4% since inception. The idea behind this bet was that the easy money in the market had been made, and investors needed to become more discerning, although the big-picture economic backdrop continued to favor a pro-cyclical, pro-risk bias in a portfolio. To achieve this goal, we opted to buy cyclicals sectors that had lagged the broad market and to sell the ones that had already overtaken their pre-COVID highs, in the hope of creating a portfolio hedge. Practically, this meant buying sectors such as Industrials, Banks and Energy, while selling sectors such as Capital goods, Autos and Consumer services (Chart 1). This position has not worked out well as yields fell. Chart 1Leaders vs Laggards The Road So Far The Road So Far UK Mid-Cap And Small-Cap To Outperform This position is up 3.4% since inception. We initially favored the more domestically-oriented mid- and small-cap indices in the UK as a bet on the re-opening trade, following the lead taken by the UK in the global vaccination campaign. A faster re-opening would not only boost the ability of smaller domestic firms to generate cash flows, it would also elevate the pound, which would hurt the profit translation of the multinational dominating the UK large-cap indices. By mid-May, we opted to move small cap back to neutral, as the positive story was well discounted and we expected the GBP to correct, which would help large-cap stocks. Favor European Banks Relative To US Ones This position is up 4.1% since inception. It is mainly a value trade. The European economy has lagged behind that of the US, and European yields remain well below US ones. As a result, European financials have greatly underperformed their US counterparts. However, this performance differential has left European banks trading at an enormous discount relative to their US peers. Hence, as continental European economies were catching up to the US on the vaccination front, we expected European banks to regain some ground. This trade has further to go, as valuation differentials remain excessive, especially since European banks are not as risky as they once were. Underweight / Short Norway As Hedge To Swedish Stocks This position is down 1% since inception. We have a cyclical overweight on the Swedish equity market (see page 9), which is extremely sensitive to the global industrial cycle. Thus, we were concerned by the potential near-term impact of the Chinese credit slowdown on this position. Selling Norway remains an appropriate hedge, because this market massively overweight materials stocks, which are even more exposed to the Chinese credit cycle than industrials are. Positive European Small-Cap Stocks This position is up 0.2% since inception. This was a bet on the economic re-opening taking place in the wake of the accelerating pace of vaccination in Europe. However, the weakness in the Euro since May has caused the large-cap European stocks to perform almost as well as their more-domestically focused counterparts. Neutral Stance On Cyclicals Relative To Defensives Chart 2The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance This trade is up 2.3% since inception. While we like cyclical plays on an eighteen to twenty-four months basis, we became concerned this spring about a tactical pullback. Globally, cyclical stocks had become extremely expensive and overbought relative to defensive sectors (Chart 2). Moreover, the rapid deceleration of the Chinese credit impulse pointed toward a period of negative economic surprises and was historically consistent with a period of underperformance of cyclical names. Now that China is stepping off the brake pedal, this trade is becoming long in the tooth. Neutral Stance On Europe Relative To The Rest of The World This trade is down 0.3% since its inception. This position is a corollary to the neutral view on cyclicals, as European equities possess a high beta. This bet did not pan out; European equities did underperform US stocks, but weaknesses in China and EM undid this benefit. Favoring Industrials Over Materials This trade is up 0.6% since inception. Industrial equities are less exposed to the Chinese credit slowdown than materials, but are more direct beneficiaries of the large infrastructure spending packages being rolled out across advanced economies. Industrials are also a direct bet on a capex recovery, which we expect to intensify over the next two years as companies address supply side issues. The tactical element of this trade may soon dissipate as China’s policy tightening ends, which would warrant booking profits. However, the industrials versus materials theme remains attractive as a cyclical bets on capex. Financials Over Other Cyclicals This trade is down 1.6% since inception. This was another trade aiming to keep some cyclical exposure on the book (long financials), while diminishing the exposure to the Chinese credit slowdown. The fall in yields and the weakness in the euro prevented this trade from working out. We now close this position. Long / Short Basket Based On Combined Mechanical Valuation Indicator This trade is flat since inception. This market-neutral trade uses the methodology developed in our May 31st Special Report in which we introduced our Combined Mechanical Valuation Indicator (CMVI). We bought the most undervalued sectors and sold the most overvalued. We will look to rebalance this portfolio in the coming months. Short Euro Area Energy Stocks / Long UK Energy Stocks Chart 3UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain This trade is up 7.5% since inception. This market neutral trade was fully based on the results from our CMVI (Chart 3). We are taking profits today. Short Consumer Discretionary / Long Telecommunication In Europe This trade is up 10.6% since inception. It is our favored way to express our tactical worries toward cyclical equities and the resulting preference for defensive stocks. Moreover, this trade is attractive from a valuation perspective, as the CMVI gap between discretionary and telecommunication equities is at a record high despite the higher RoE offered by telecom equities (Chart 4). Short Tech / Long Healthcare In Europe This trade is up 9.3% since inception. It is a low-octane version of the short discretionary / long telecommunications position. While it is a short cyclicals / long defensive trade, it does not have the long value / short growth overlay as its higher-octane cousin. However, it is also supported by attractive valuation differentials (Chart 5). Chart 4An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... Chart 5...and A Lower Octane Expression ...and A Lower Octane Expression ...and A Lower Octane Expression Favor Spain Over France This trade is down 2% since inception. Based on sectoral composition, the Spanish market is more defensive than that of France, which was an appealing characteristic considering our tactical worries for cyclical bets. Moreover, Spanish equities were more attractively priced. However, the Spanish economy has proven less resilient to the Delta variant than that of France. As a result, Spanish financials, which represent a large share of the national benchmark, have suffered. Underweight French Consumer Discretionary Equities Relative To Global Peers This trade is up 0.6% since inception. French discretionary stocks, led by beauty and luxury names, remain attractive structural plays. However, they have become expensive and risk temporarily underperforming their foreign competitors. Buy Swiss Equities / Sell Eurozone Defensive This trade is up 0.5% since inception. Due to their sectoral bias toward consumer staples and healthcare, Swiss equities are extremely defensive. However, they often outperform their Euro Area counterparts when Swiss yields rise relative to those of Germany. We do expect such widening to take place over the coming months. The ECB will continue to expand its balance sheet, which will force the SNB to become increasingly active about putting a floor under EUR/CHF. Historically, these processes boost Swiss stocks relative to Eurozone defensives. Buy European Momentum Stocks / Sell European Growth Stocks Chart 6The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further This trade is up 1.7% since inception. In Europe, momentum stocks are exceptionally oversold relative to growth stocks (Chart 6). As yields stabilize, momentum stocks are well placed to outperform growth equities. Moreover, this trade is a careful attempt to begin to move away from our defensive tactical stance as China backs away from policy tightening. More Value Left In European IG This trade is up 0.9% so far. European IG bonds have low spreads, but their breakeven spreads may narrow further as policy remains extremely accommodative and European growth continues to recover, even in the face of the Delta variant. In this context, we see the modest yield pick-up offered by these products as attractive, especially compared to the meagre yields generated by European safe-haven securities. Despite the modest success of the overall recommendation, the country implication did not work out as well. Overweight Italian And Spanish Bonds In Balance Portfolios This trade is up 0.2% since inception. Italian and Spanish government bonds are expensive in absolute terms, but compare well relative to French, Dutch, or German bonds. In a backdrop in which the ECB continues to purchase these instruments, where the NGEU funds create an embryo of fiscal risk-sharing within the EU and where growth is recovering, risk premia in the European periphery have room to decline further. Buy European Steepeners And US Flatteners As A Box Trade Chart 7Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners This trade is up 63 bps since inception. The ECB will lag behind the Fed, but market pricing already reflects this future. Meanwhile, the terminal policy rate proxy embedded in the EONIA and US OIS curves overstates how high the neutral rate is in the US compared to that of Europe (Chart 7). Thus, as the Fed begins to remove accommodation in the US, the US yield curve should flatten compared to that of Europe. Favor The GBP Over The EUR This trade is up 0.6% since inception. The pound is cheaper than the euro, and the domestic UK economy is well supported by the more advanced re-opening process. This combination will continue to hurt EUR/GBP. Sell EUR/NOK This trade is down 2.6% since inception. The NOK is cheaper than the EUR, and the Norges Bank will lead DM central banks in raising interest rates. Moreover, higher oil prices create a positive term of trade shock in favor of Norway. However, this trade has not worked out so far. Among G-10 currencies, the NOK (along with the SEK) is the most sensitive to the USD’s fluctuations. The rebound in the Greenback since March has therefore hurt this position significantly. Cyclical Recommendations Overweight Stocks Vs Bonds This position is up 7% since inception. European equities follow the global business cycle; while we warned a slowdown would take shape, growth is slated to remain above trend for the foreseeable future. Consequently, while we may adjust tactical positioning to take advantage of these gyrations in growth relative to expectations, our core cyclical view remains to overweight stocks within European balanced portfolios. Overweight Bank Equities Chart 8Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore This position is up 2.4% since inception. We have espoused the near-term decline in yields, but our big picture cyclical view remains that yields have more upside globally. An environment in which yields increase is one in which bank profit margins expand, which will in turn boost the relative return of cheap financial equities. Even though the long-term growth rate of bank cash flows warrants a discount, these firms’ valuations also reflect the perception that they carry elevated risks. However, if European NPLs have greatly improved, capital buffers have expanded significantly (Chart 8), and the ECB is unwilling to precipitate a crisis as it did ten years ago. In this context, the risk premia embedded in European bank valuations have room to decrease, which will boost the relative performance of these equities. Bullish German Equities (Absolute) This position is up 3.9% since inception. German stocks are a direct bet on the global economy, as a result of their heavy weighting in industrials and consumer discretionary stocks. Moreover, the German economy continues to fare well, boosted by a cheap euro and a low policy rate. Finally, we expect German fiscal policy to remain accommodative after the upcoming federal election weakens the power of the CDU. This combination will allow German stocks to generate further upside over the coming years. Favor Swedish Equites Over Eurozone And US Benchmarks Since inception, this position is up 0.9% on its European leg and is up 0.3% on its US leg. Sweden is a particularly appealing market despite its demanding valuations. The Swedish benchmark overweighs industrials and financials, two of our favorite sectors for the coming eighteen months. Moreover, the Swedish corporate sector’s operating metrics are robust, with wide profit margins, elevated RoEs, and comparatively healthy levels of leverage. Finally, the SEK is one of our favored currencies on a twenty-four-month basis, because it has a strong beta to the USD, which BCA expects to depreciate on a cyclical time frame. Buying Sweden versus the Eurozone has worked out, but selling the US market has not, because yields experienced a countertrend decline. Once global yields begin to rise anew and Chinese credit growth begins to recover, Swedish equities should also beat their US peers. Long Swedish Industrials / Short Eurozone And US Industrials Chart 9Favor Swedish Industrials Favor Swedish Industrials Favor Swedish Industrials This position is up 3% on its European leg and 8.5% on its US one. This market neutral position narrows in on the very reason to favor Swedish equities: industrials. As is the case for the overall market, Swedish industrials offer stronger operating metrics than their counterparts in both the Eurozone and the US (Chart 9). Additionally, the early positioning of Sweden in global supply chains adds some operating leverage to these firms, which gives them an advantage in an environment of continued inventory rebuilding, infrastructure spending, and capex plans around the world. Underweight German Bunds Within European Fixed-Income Portfolios German bund yields have declined 15bps since inception. German Bunds suffer from their extremely demanding valuations versus other European fixed-income securities. As long as global and European growth remains above trend, German yields should underperform other European fixed-income assets, even if the ECB stands pat for the foreseeable future (which would force greater spread compression across European markets). Weakness In EUR/USD Creates Long-Term Buying Opportunities Earlier this spring, we expected the dollar to experience a counter-trend bounce as a result of skewed positioning and the potential for a decline in global growth surprises. However, BCA’s cyclical view calls for a weaker USD because of the US balance of payments deficit, the greater tolerance of the Fed for higher inflation, and the overvaluation of the Greenback. Based on these diverging forces, we continue to recommend investors use the current episode of weakness in EUR/USD as an opportunity to garner more exposure to the euro. Short EUR/SEK This position is down 0.6% since inception. The SEK is even more sensitive to the dollar’s gyration than the euro. Moreover, beyond some near-term disappointment in global economic activity, we expect global growth to remain generally robust over the coming eighteen months. This combination will allow the SEK to appreciate versus the EUR, especially when Sweden’s domestic economic activity and asset markets are stronger than that of the Eurozone. Structural Recommendations A Structural Underweight On European Financial Chart 10Too Much Capital Too Much Capital Too Much Capital This long-term position is at odds with our near-term optimism about the sector. However, Europe has an excessively large capital stock, which, relative to GDP, dwarves that of the US or China (Chart 10). This phenomenon hurts rate of returns across the region and will remain a long-term structural handicap for the financial industry. Hence, investors with long investment horizons should use the expected rebound in European financials over the next year or two to diminish further their exposure to that sector. Norwegian Equities Remain Challenged As Long-Term Holdings Norwegian stocks overweight the financials, materials, and energy sectors. While materials face a bright future as electricity becomes an even more important component of the global energy mix, financials and energy face deep structural headwinds. Moreover, the krone faces its own structural challenges (see below). This combination augurs poorly for the long-term rates of return of Norwegian stocks. Overweight French Industrials Relative To German Ones This position is a bet on the continuation of the reform efforts of the French economy. BCA expects Emmanuel Macron to win a second mandate next year, which should result in additional reforms to the French economy. As a result, the French unit labor costs should remain contained relative to those of Germany. This process will help the profit margins of French industrial firms relative to that of their competitors across the Rhine. Overweight French Tech Equities Relative To European Ones French tech stocks will benefit from the greater R&D subsidies and budgets promoted by the French government. The Euro Will Underperform Pro-Cyclical European Currencies The Swedish krona and the British pound are particularly attractive versus the euro on a long-term basis. They benefit not only from their cheaper valuations, but also from the fact that the Riksbank and the Bank of England will tighten policy considerably ahead of the ECB. Additionally, the SEK and the GBP are now both more pro-cyclical than the euro. The Norwegian Krone Faces Structural Challenges The NOK is cheap and may even benefit in the coming month from its historical pro-cyclicality. However, Norway suffers from declining productivity relative to that of its trading partners, which creates a strong long-term handicap for its currency. As a result, long-term investors should withdraw from the NOK.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Road So Far The Road So Far Cyclical Recommendations The Road So Far The Road So Far Structural Recommendations The Road So Far The Road So Far ​​​​​​​ Currency Performance Fixed Income Performance Equity Performance