Fixed Income

Highlights Chart 1How Long Until Full Employment? How Long Until Full Employment? How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification It’s A Boom! It’s A Boom! Table 2Fixed Income Sector Performance It’s A Boom! It’s A Boom! Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s A Boom! It’s A Boom! Table 3BCorporate Sector Risk Vs. Reward* It’s A Boom! It’s A Boom! 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 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 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 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. 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 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. 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 March 31ST, 2021) It’s A Boom! It’s A Boom! 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 March 31ST, 2021) It’s A Boom! It’s A Boom! 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 43 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 43 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) It’s A Boom! It’s A Boom! 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 March 31st, 2021) It’s A Boom! It’s A Boom! Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance

Highlights The Eurozone economy and assets remain beholden to the global manufacturing cycle. This sensitivity reflects the large share of output generated by capex and exports. Yet, the second half of 2021 and first half of 2022 could see euro area growth follow the beat of its own drum. This is a consequence of the unique role of consumption in the COVID-19 recession. European growth will therefore outperform expectations, even if economic momentum slows outside of Europe. Consequently, the euro and Eurozone equities will outperform for the coming 12 to 18 months. Feature For the past 20 years, investors have used a simple rule of thumb to understand European growth and markets. Europe is a derivative of global growth because of its large manufacturing sector and torpid domestic economy. A reductionist approach would even argue that China’s economy is what matters most for Europe. Is this model still valid to analyze Europe? In general, this approach still holds up well. However, the nature of the 2020 COVID-19 recession suggests that the European economy could still accelerate in the second half of the year, despite a small slowdown in the Chinese economy and global manufacturing sector. The Origin Of The Pro-Cyclicality Narrative Investors in European markets have long understood that Eurozone equities outperform when the global manufacturing cycle accelerates. This pro-cyclicality of European stocks is a consequence of their heavy weighting toward cyclical and value stocks, such as industrials, consumer discretionary and financials. Chart 1German/US Spreads: Global Manufacturing Cycle German/US Spreads: Global Manufacturing Cycle German/US Spreads: Global Manufacturing Cycle Historically, European yields have also moved in a very pro-cyclical fashion. Over the past 30 years, periods when German 10-year yields rose relative to that of US Treasury Notes have coincided with an improvement in the global manufacturing sector as approximated by the ISM Manufacturing survey (Chart 1). Investors also understand that the euro is a pro-cyclical currency. Some of this behavior reflects the counter-cyclicality of the US dollar. However, if German yields rise more than US ones when global growth improves and European equities outperform under similar conditions, the euro naturally attracts inflows when the global manufacturing sector strengthens. Chart 2China Is A Key Determinant Of European Activity China Is A Key Determinant Of European Activity China Is A Key Determinant Of European Activity Ultimately, the responsiveness of the euro and European assets to global growth is rooted in the nature of the European economy. Trade and manufacturing account for nearly 40% and 14% of GDP, respectively, compared to 26% and 11% for the US. This economic specialization has made Europe extremely sensitive to the gyrations of the Chinese economy, the largest contributor to fluctuation in the global demand for capital goods. As Chart 2 highlights, European IP and PMI outperform the US when China’s marginal propensity to consume (as approximated by the growth in M1 relative to M2) picks up. Is The Pro-Cyclical Narrative Still Valid? Despite the euro area debt crisis and the slow health and fiscal policy response of European authorities to COVID-19, evidence suggests that the Eurozone’s pro-cyclicality is only increasing. Chart 3Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World A simple statistical analysis confirms this hypothesis. A look at the beta of European GDP growth against the Global PMI reveals that the sensitivity of Eurozone growth and German growth to the Global PMI has steadily increased over the past 20 years (Chart 3, top panel). Moreover, the beta of euro area growth to the global PMI is now higher than that of the US, despite a considerably lower potential GDP growth, which means that a greater proportion of the Eurozone’s GDP growth is affected by globally-driven fluctuations. The bottom panel of Chart 3 shows a more volatile but similar relationship with Chinese economic activity. Correlation analysis confirms that Europe remains very sensitive to global factors. Currently, the rolling correlation of a regression of Eurozone GDP growth versus that of China stands near 0.7, which is comparable to levels that prevailed between 2005 and 2012. The correlation between German and Chinese GDP growth is now higher than at any point during the past two decades. Chart 4The Declining Role Of Consumption The Declining Role Of Consumption The Declining Role Of Consumption The increasing influence of global economic variables on the European economy reflects the evolution of the composition of the Eurozone’s GDP. Over the past 11 years, the share of consumption within GDP has decreased from 57% to 52%. For comparison’s sake, consumption accounts for 71% of US GDP. The two sectors that have taken the primacy away from consumption are capex and net exports, whose combined share has grown from 22% to 26% of GDP (Chart 4). This shift in the composition of GDP echoes the structural forces facing the Eurozone. An ageing population, a banking system focused on rebuilding its balance sheet, and the tackling of the competitiveness problems of peripheral economies have hurt wage growth, consumption and imports. Meanwhile, exports have remained on a stable trend, thanks to both the comparative vigor of the euro area’s trading partners and a cheap euro. Therefore, net exports expanded. Capex benefited from the strength in European exports. A Granger causality test reveals that consumption has little impact on fixed-capital formation in the euro area. However, the same method shows that fluctuations in export growth cause changes in investment. This makes sense. The variance in exports is an important contributor to the variability of Eurozone profits (Chart 5). Thus, rising exports incentivize the European corporate sector to expand its capital stock to fulfill foreign demand. The expanding share of output created by exports and capex along with the role of exports as a driver of capex explains why Europe economic activity is bound to remain so sensitive to the fluctuations in global trade and manufacturing activity. Moreover, the capex/exports interplay even affects consumption. As Chart 6 shows, the growth of euro area personal expenditures often bottoms after the annual rate of change of the new orders of capital goods has troughed, which reflects the role of exports as a driver of European income. Chart 5Profits And Exports Profits And Exports Profits And Exports Chart 6Consumption Doesn't Move In A Vacuum Consumption Doesn't Move In A Vacuum Consumption Doesn't Move In A Vacuum Bottom Line: European economic activity remains a high beta play on global and Chinese growth. The decrease in consumption to the benefit of exports and capex explains why this reality will not change anytime soon. 2021, An Idiosyncratic Year? In 2021, consumption will be the key input to the European economic performance, despite the long-term relationship between European GDP and foreign economic activity. This will allow European growth to narrow some of its gap with the US and the rest of the world in the second half of this year and the first half of 2022, even if the global manufacturing sector comes off its boil soon. The 2020 recession was unique. In a normal recession, capex, real estate investment, spending on durable goods and the manufacturing sector are the main contributors to the decline in GDP. This time, consumption and the service sector generated most of the contraction in output. These two sectors also caused the second dip in GDP following the tightening of lockdown measures across Europe last winter. Once the more recent wave of lockdowns is behind us, consumption will most likely slingshot to higher levels. More than the US, where the economy has been partially open for months now, Europe remains replete with significant pent-up demand. Obviously, fulfilling this demand will require further progress in the European vaccination campaign, something we recently discussed. Chart 7The Money Supply Forecasts A Rapid Recovery The Money Supply Forecasts A Rapid Recovery The Money Supply Forecasts A Rapid Recovery The surge in M1 also points to a sharp rebound in consumption once governments lift the current lockdowns (Chart 7). M1 is a much more reliable predictor of economic activity in Europe than in the US, because disintermediation is not as prevalent in the Eurozone, where banks account for 72% and 88% of corporate and household credit, respectively, compared to 32% and 29% in the US. We cannot dismiss the explosion in the money supply as only a function of the ECB’s actions. European banks are in much better shape today than they were 10 years ago. Non-performing loans have been steadily decreasing. A rise in delinquencies is likely in the coming quarters due to the pandemic; however, the EUR3 trillion in credit guarantees by governments will limit the damages to the private sector’s and banking system’s balance sheets. Moreover, the Tier-1 capital ratio of the banking system ranges between 14% for Spain and 17% for Germany, well above the 10.5% threshold set by Basel-III (Chart 8). In this context, the pick-up in money supply mirrored credit flows. Thus, even if some of that credit reflects precautionary demand, the likelihood is high that a significant proportion of the built-up cash balances will find its way into the economy. Another positive sign for consumption comes from European confidence surveys. Despite tighter lockdown measures, consumer confidence has sharply rebounded, which historically heralds stronger consumption. Moreover, according to the ECB’s loan survey, stronger consumer confidence is causing an improvement in credit demand, which foreshadows a decline in savings intentions, especially now that wage growth is stabilizing (Chart 9). Nonetheless, there is still a risk that the advance in wages peters off. The recent wage agreement reached by Germany’s IG Metall union in North Rhine Westphalia was a paltry 1.3% annual pay raise, and once the Kurzarbeit programs end, the true level of labor market slack will become evident. However, for consumption to grow, all that we need to see now is stable wage growth, even if at a low rate.  Chart 8European Banks Are Feeling Better European Banks Are Feeling Better European Banks Are Feeling Better Chart 9Confidence Points To Stronger Consumption Confidence Points To Stronger Consumption Confidence Points To Stronger Consumption Beyond consumption, Europe’s fiscal policy will be positive compared to the US next year. The NGEU plan will add roughly 1% to GDP in both 2021 and 2022. As a result, the Eurozone’s net fiscal drag should be no greater than 1% of GDP next year. This compares to a fiscal thrust of -7% in the US in 2022, even after factoring in the new “American Jobs Act” proposed by the Biden Administration last week, according to our US Political Strategy team. Bottom Line: The revival in European consumption in the second half of 2021 and the first half of 2022 will allow the gap between European and global growth to narrow. This dynamic will be reinforced next year, when the fiscal drag will be lower in Europe than in the US. These forces will create a rare occasion when European growth will improve despite a deceleration (albeit a modest one) in global manufacturing activity. Investment Conclusions The continued sensitivity of the euro area economy to the global industrial and trade cycle indicates that over the long-term, European assets will remain beholden to the gyrations of global growth. In other words, the euro and European stocks will outperform in periods of accelerating global manufacturing activity, as they have done over the past 30 years. The next 12 to 18 month may nonetheless defy this bigger picture, allowing European assets to generate alpha for global investors. Chart 10The Euro Will Like Idiosyncratic European Growth The Euro Will Like Idiosyncratic European Growth The Euro Will Like Idiosyncratic European Growth First, the gap between US and euro area growth will narrow over the coming 12 to 18 months, thus the euro will remain well bid, even if the maximum acceleration in global industrial activity lies behind. As investors re-assess their view of European economic activity and the current period of maximum relative pessimism passes, inflows into the euro area will accelerate and the euro will appreciate (Chart 10). Hence, we continue to see the recent phase of weakness in EUR/USD as transitory. Second, European equities have scope to outperform US ones over that window. Some of that anticipated outperformance reflects our positive stance on the euro. However, a consumption-driven economic bounce will be positive for European financials as well. Such a recovery will let investors ratchet down their estimates of credit losses in the financial system. Moreover, banks are well capitalized, thus the ECB will permit the resumption of dividend payments. Under these circumstances, European banks have scope to outperform US ones temporarily, especially since Eurozone banks trade at a 56% discount to their transatlantic rivals on a price-to-book basis. An outperformance of financials will be key for Europe’s performance. Chart 11German/US Spreads Near Equilibrium? German/US Spreads Near Equilibrium? German/US Spreads Near Equilibrium? Finally, we could enter a period of stability in US/German yield spreads over the coming months. The ECB remains steadfast at limiting the upside in European risk-free rates, as Christine Lagarde reiterated last week. However, BCA’s US bond strategist, Ryan Swift, believes US yields will enter a temporary plateau, as the Federal Reserve will not adjust rates until well after the US economy has reached full employment. Hence, the Fed is unlikely to let the OIS curve bring forward the date of the first hike currently priced in for August 2022 on a durable basis, which also limits the upside to US yields. Thus, looking at core CPI and policy rate differences, US yields have reached a temporary equilibrium relative to Germany (Chart 11).   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Dear client, In addition to this abbreviated weekly report, we are also sending you an in-depth report on the euro, written by my colleague Mathieu Savary. Mathieu argues that the euro could continue to face some downside in the near-term, creating perfect conditions for a buying opportunity below 1.15. We agree with Mathieu’s assessment and are shorting EUR/JPY this week as a tactical trade. Finally, last week, we held a webcast during which I discussed the key themes that will shape the dollar landscape in the coming months. In case you missed it, you can listen to the replay here. Kind regards, Chester Highlights Being long the dollar is now a consensus trade. A new US infrastructure bill will be positive for US growth. However, the new package also increases the probability that inflation will be higher in the US, which will depress relative real rates. Go short EUR/JPY as a tactical trade. Feature Chart I-1Dollar Sentiment Has Been Reset Dollar Sentiment Has Been Reset Dollar Sentiment Has Been Reset The DXY index is fast approaching our 94-95 target and it is an open question whether the rally will stall at these levels, or punch through for new highs this year. Historically, the dollar has tended to move in long cycles, with the latest bull and bear markets lasting about a decade or so. If, as we believe, a dollar bear market did indeed commence in 2020, then the historical evidence is that any bounce will be capped around 4-6%. This was the experience of the 2000s. The defining landscape during the latter stages of the dollar bull market in 2018 and 2019 was deteriorating global growth, with financial conditions which remained relatively too tight. The situation today is extremely easy financial conditions and improving global growth. As such, our bias remains that the landscape is more characteristic of a dollar bear market.  Speculators are now long the dollar and our capitulation index is approaching overbought levels (Chart I-1). So while there is scope for the dollar to continue to rise in the near term, the big gains are behind us. US Infrastructure Spending And Bond Yields President Joe Biden’s American Jobs Plan did little to lift US long bond yields. This suggests that most of the improvement to aggregate demand may have already been priced in. The big driver of the US dollar this year has been the improvement in yields, particularly at the long end of the curve. Short yields have remained anchored near zero (Chart I-2). If this improvement in long rates is torpedoed by lack of bi-partisan support for a larger fiscal package, then this will provide less scope for the US dollar to rise. Economically, a large infrastructure package makes sense. The neutral rate of interest in the US is well above the Fed funds target rate. A widening gap suggests underlying financing conditions (short rates) are low relative to the potential growth rate of the economy (long rates). Not surprisingly, this also tends to track the yield curve pretty closely (Chart I-3). This incentivizes banks to lend, and fund these projects. Chart I-2The Move In Rates Has Been On The Long End The Move In Rates Has Been On The Long End The Move In Rates Has Been On The Long End Chart I-3A Steeping Curve Usually Encourages Lending A Steeping Curve Usually Encourages Lending A Steeping Curve Usually Encourages Lending The feedback loop with the dollar could however be negative. First, while the boost to aggregate demand supports US growth in the short term, there will be spillovers to other countries. The net beneficiaries might also be the countries that have the raw materials needed to realize this infrastructure plan. The proposal has a largely “buy American” tilt, but this will also create sharp domestic shortages as the US is not a manufacturing-based economy. An increase in imports will widen the US trade deficit. Second, the returns on infrastructure investments tend to be large in lower-productivity countries. Meanwhile, the increase in US taxes to fund these deficits will lower the return on capital for US assets. This might limit foreign inflows into US capital markets. Third, the US output gap is slated to close faster than in other economies, meaning the increase in aggregate demand will soon become inflationary. This could further depress real rates in the US. There is a longstanding correlation between US relative real rates and the dollar (Chart I-4). Chart I-4The Dollar Moves With Relative Real Rates The Dollar Moves With Relative Real Rates The Dollar Moves With Relative Real Rates Chart I-5The Dollar Is Overvalued The Dollar Is Overvalued The Dollar Is Overvalued Finally, it is important to remember that the starting point for the US dollar is as an expensive currency. According to our PPP models, the dollar is overvalued by over 10% (Chart I-5). This is already manifesting itself in a deteriorating trade balance. It also suggests that should the dollar continue to rise significantly, it will negatively impact US growth. Trading Strategy Amidst Market Uncertainty The near term outlook for the dollar remains bullish. Vaccinations are progressing at the fastest pace in the US and in the UK while the euro area, Canada and Japan are seeing a third wave of infections underway (Chart I-6). New lockdown measures have been implemented in these latter countries, which will further dent their Q2 outlook. While our bias is that these economies eventually benefit as their vaccination program progresses, the dollar remains in a sweet spot for now. Chart I-6AA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway Chart I-6BA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway Chart I-6CA Third Wave Is Underway A Third Wave Is Underway A Third Wave Is Underway One hedge to this scenario is to go short the EUR/JPY cross. First, our Chief European Investment Strategist Mathieu Savary argues that the euro could undershoot to 1.12 in the near term. This suggests that EUR/JPY which faces critical resistance a nudge above 130, will stage a countertrend reversal (Chart I-7). Both EUR/USD and EUR/JPY tend to be positively correlated. Second, European bourses are underperforming those in Japan in common-currency terms. The relative performance of the equity markets have usually moved in lockstep with the currency, but a divergence has opened up (Chart I-8). In fact, given very similar sector compositions across both bourses, this divergence might be down to competitiveness, given the rally in EUR/JPY. Should profits in Europe suffer relative to those in Japan, this will cap EUR/JPY gains (Chart I-9) Chart I-7EUR/JPY Faces Strong Resistance At 130 EUR/JPY Faces Strong Resistance At 130 EUR/JPY Faces Strong Resistance At 130 Chart I-8EUR/JPY Moves With Relative Share Prices EUR/JPY Moves With Relative Share Prices EUR/JPY Moves With Relative Share Prices   Chart I-9EUR/JPY And Relative Profits EUR/JPY And Relative Profits EUR/JPY And Relative Profits Finally, monetary policy is more accommodative in Europe than in Japan. Interest rates are lower, and the ECB’s balance sheet is rising more aggressively. This has historically been accompanied by a lower EUR/JPY exchange rate (Chart I-10). Chart I-10EUR/JPY And Relative Monetary Policy EUR/JPY And Relative Monetary Policy EUR/JPY And Relative Monetary Policy We eventually expect EUR/JPY to break higher, but for now, we are opening a short position in this cross as a portfolio hedge. In line with this view, we are tightening stops on all of our trades this week. The dollar could be set for violent moves in the coming weeks. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature The global macro landscape over the next six months or so will be characterized by a booming US economy and decelerating growth in China. Financial markets will move accordingly. US Treasury yields will remain under upward pressure, the US dollar will rebound, commodities prices will experience a setback and EM equities will continue underperforming DM stocks. The upcoming US economic boom is a well-known narrative and does not require much elaboration. China’s slowdown, on the other hand, is a matter of debate among investors and commentators. We have been arguing that macro policy tightening and a resumption of regulatory clampdowns on the financial system and property market are bound to result in a growth deceleration in China. There are already leading indicators that point to an impending growth slowdown: Chart 1China Is Set To Decelerate China Is Set To Decelerate China Is Set To Decelerate The latest datapoint for domestic orders from the PBOC’s survey of 5000 industrial enterprises has relapsed in Q1. It leads A-share companies EPS growth by six months (Chart 1, top panel). The message is that industrial companies’ profit growth will once again slow in H2 2021. The recent setback in Chinese A-shares is evidence that markets are already beginning to price in a profit deceleration in H2. The bottom panel of Chart 1 indicates that banks’ claims on enterprises and households have rolled over and will continue downshifting. This is consistent with easing bank loan approvals and reflects policymakers’ guidance for banks. In Charts 3, 4, 6, 7, 8, 9, 10, 11 and 13 below, we illustrate more indicators and evidence of a forthcoming peak in the Chinese business cycle in general and commodities prices in particular. Weakening growth in China will hurt EM stocks and currencies more than those in DM, as many emerging economies are exposed to industrial commodities that are much more sensitive to demand in China versus trends in the US. Also, many Asian economies export more to China than they do to the US and Europe. Besides, the growth outlook in EM (ex-China, Korea and Taiwan) remains sub-par, especially relative to the US and DM more broadly. The reasons for this are slower vaccination rates and by extension economic reopening, a lack of fiscal stimulus and unhealthy banking systems. Notably, Chart 39 below demonstrates that EM bank stocks are breaking down relative to DM bank stocks. This potential breakdown reflects the state of EM fundamentals relative to those of DM. This week we recommend a new trade: short EM banks / long DM banks. In the US, the feature story will be the brisk pace of its reopening, an economic boom and intensifying inflationary pressures. So long as US bond yields continue rising, the US dollar will be supported. The next downleg in the greenback will occur when inflation rises but the Fed explicitly refuses to tackle it. Odds are that we are several months away from that. Hence, rising US bond yields will prop up the US dollar for now. The rebound in the US dollar and rising US bond yields will weigh on EM fixed income. The bottom panel of Chart 30 below illustrates that EM credit spreads negatively correlate with commodity prices. All in all, EM credit spreads will likely widen. Together with ascending US Treasury yields, this means higher EM sovereign and corporate dollar bond yields. The latter have always been associated with lower EM share prices (Chart 2, top panel). Chart 2Rising Corporate Bond Yields Are A Threat To Stocks Rising Corporate Bond Yields Are A Threat To Stocks Rising Corporate Bond Yields Are A Threat To Stocks Strategy: As a tactical strategy (three to six months), last week we recommended downgrading the allocation to EM within global equity and credit portfolios from neutral to underweight. We also recommended shorting a basket of the following EM currencies versus the US dollar for the next several months: HUF, PLN, PHP, TRY, CLP, ZAR, KRW, BRL and THB. Strategic portfolios should maintain neutral allocations to EM equities, credit, local bonds and currencies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chinese Share Prices Point To A Top In Commodities Prices The recent underperformance of Chinese onshore cyclical stocks relative to defensive stocks heralds a slowdown in growth and has historically been a good indicator for raw materials prices. Consistently, the latest pullback in share prices of materials companies included in the MSCI China Investable Index also signals a drop in industrial metals prices. Chart 3Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chart 4Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Commodities: New Secular Bull Market Or A Trading Range? Various Chinese liquidity and money measures have historically led the CRB Raw Materials Price Index and presently signal a relapse in commodities. The 200-year chart showing raw materials (excluding oil and gold) prices in real (inflation-adjusted) terms suggests that commodities prices have not undershot their long-term time-trend (Chart 5). We do not argue for a continuation of a structural bear market in commodities, but a medium-term setback is likely in the next three to six months. Chart 5Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Chart 6Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Chart 7Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 The rally in EM share prices last year has priced the ongoing profit recovery. However, the apex in Chinese money/credit measures entails an EM profit slowdown in H2 this year (Chart 8). Besides, the considerable pullback in Chinese cyclicals-to-defensive stock prices implies further drawdown in EM share prices. Chart 8EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 Chart 9EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 The Chinese Economy: Shifting Into Low Gear In China, liquidity and money measures portend a peak business cycle. Excluding TMT companies, Chinese investable stocks have failed to break above their trading range of the past ten years. Notably, the slowdown is not limited to the old economy. The Caixin New Economy Index has dropped to its early 2019 level. Chart 10The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 11The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 12The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 13The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Peak Growth And Equity Sentiment We have been showing Chart 14 for the past several months. The record high sentiment on EM equities in January preceded with an apex in EM share prices in February. This measure of sentiment is not yet low enough to expect a bottom in EM stocks. Chart 15 shows a similar indicator for euro area equities. Will it play out in the euro area as it did with EM? Chart 14Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Chart 15Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment The numbers of IPOs and secondary issuances have risen to a record high in China and EM. Often, this development is consistent with peak investor sentiment that coincides with some sort of top in share prices. Chart 16Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Chart 17Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Chart 18Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity earnings yield minus interest rates (a proxy for equity risk premium) in EM is similar to that of the US. Hence, adjusted for local interest rates, EM stocks are not cheap. In fact, European and Japanese stocks are cheaper than EM stocks. Chart 19Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Chart 20Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities A US Dollar Rebound = EM Setback Both EM equity recent selloffs and relative underperformance versus DM occur alongside US dollar strength. Besides, EM equity relative performance often moves counter to US stocks relative performance against the global benchmark (Chart 23). Finally, emerging Asian stocks’ relative performance versus the global index has hit a major technical resistance. The path of least resistance is, for now, on the downside. Chart 21A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 22A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 23A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 24A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback EM Stocks Have Formed A Medium-Term Top The EM overall equity benchmark (shown in Chart 20) as well as EM ex-TMT stocks, EM (ex-China, Korea and Taiwan) share prices, EM small caps and the EM equal-weighted index have so far failed to break out.  The forthcoming slowdown in China, rising US Treasury yields, the US dollar rebound and poor fundamentals in EM (ex-China, Korea and Taiwan) are consistent with these technical patterns and warrant caution for now. Chart 25EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 26EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 27EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 28EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Investor sentiment on US Treasurys is neutral, as is JP Morgan’s duration survey. Major market moves do not halt when sentiment is neutral but rather persist until sentiment becomes extreme. This and the economic boom and rising inflationary pressures in the US are the basis for higher US bond yields. The latter will push up both EM local currency and US dollar bond yields. In turn, a relapse in commodities prices will lead to a widening EM credit spread. Chart 29Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income The US Dollar Rebound Is In The Making The US dollar will continue its rebound as the US economic growth outpaces others and US yields rise relative to their peers. In turn, a rollover in commodities prices is a harbinger of EM currency weakness. Chart 30The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 31The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 32The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 33The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World US import prices are rising in US dollar terms but not enough to offset exporters’ currency appreciation of the past 12 months. In fact, export prices in local currency terms have been tame in China and Korea. The greenback might appreciate in the near term to redistribute inflationary pressures from the US to the rest of the world, where the risk remains deflation/disinflation. Chart 34A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World Chart 35A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World EMs’ Poor Fundamentals In recent weeks, Brazil and Russia have hiked their policy rates. However, core consumer price inflation in both countries remains well behaved. Both economies are sluggish. In short, economic growth and inflation did not herald higher policy rates. Higher borrowing costs will jeopardize growth in these and other EM economies. Critically, the breakdown in EM relative to DM bank share prices (Chart 39) is a sign of poor health of EM banks and their inability to finance the economic recovery. Chart 36EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Chart 37EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Chart 38EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Investment Ideas A few of our investment recommendations outside our main strategy are: (1) long Chinese A-shares / short investable stocks; (2) long global value / short Chinese investable value stocks; (3) long global industrials / short global materials; (4) short a basket of EM currencies versus the US dollar or go long EM currency volatility. This week we are adding  a new recommendation: short EM banks / long DM banks (Chart 39). Chart 39Investment Ideas Investment Ideas Investment Ideas Chart 40Investment Ideas Investment Ideas Investment Ideas Chart 41Investment Ideas Investment Ideas Investment Ideas   Footnotes Equities Recommendations Growth Divergence: Booming US, Slowing China Growth Divergence: Booming US, Slowing China Currencies, Credit And Fixed-Income Recommendations

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Rates Are Rising Everywhere Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Global Excess Savings Total $3 Trillion Global Excess Savings Total $3 Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Chart 6Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 ...Since This Is As Early As Q3 2021 ...Since This Is As Early As Q3 2021 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing ...With The Possible Exception Of Housing ...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global Economy Chart 18US Growth Already Looks Strong... US Growth Already Looks Strong... US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening China Is Risking Overtightening China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places Financials And Tech: Trading Places Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Stay Long TIPS Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Limited Upside For Oil From Here Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Turning More Positive On Private Equity Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Is Perfection Priced In? Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? China Slowing Again? China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

Highlights Underweighting T-bonds, tech versus the market, growth versus value, new economy versus old economy, and US versus the euro area are all just one massive correlated trade. Get the direction of the T-bond yield right, and you will get the whole correlated trade right. The rise in the 10-year T-bond yield will meet resistance much closer to 2 percent than to 3 percent… …because the level of the yield is already starting to weigh on the stock market, the financial system, and the real economy. Hence, on a 6-month horizon, fade the massive correlated trade. When allocating to stock markets, don’t confuse a ‘stock effect’ for a ‘country effect’. Fractal trade shortlist: European autos and European personal products. The Pareto Principle Of Investment Chart of the WeekCorrelated Trade: Tech And The US Correlated Trade: Tech And The US Correlated Trade: Tech And The US One of the guiding principles of investment is that: Investment is complex, but it is not complicated. The words complex and complicated are often used synonymously, but they mean different things. Complex means something that is not fully predictable or analysable. Complicated means something that is made up of many parts. Investment is not complicated because a few parts drive the relative prices of everything. This is also known as the Pareto Principle, or the 20:80 rule. Just 20 percent of the input determines 80 percent of the output.1 Right now, the 20 that is determining the 80 is the bond yield. Higher bond yields are hurting high-flying tech stocks. This is because the ‘net present value’ of cashflows that are weighted deep into the future are highly sensitive to rising yields. Therefore, underweighting T-bonds means underweighting tech versus the market. Which extends to growth versus value, new economy versus old economy, US versus the euro area, and so on. In effect, all these positions have become one massive correlated trade (Chart of the Week, Chart I-2, and Chart I-3). Chart I-2Correlated Trade: T-Bond, And Growth Vs. Value Correlated Trade: T-Bond, And Growth Vs. Value Correlated Trade: T-Bond, And Growth Vs. Value Chart I-3Correlated Trade: Growth Vs. Value, ##br##And Tech Correlated Trade: Growth Vs. Value, And Tech Correlated Trade: Growth Vs. Value, And Tech Get the direction of the bond yield right and your whole investment strategy will be right. You will be a hero. Get the direction of the bond yield wrong and your whole investment strategy will be wrong. You will be a zero. Get the direction of the bond yield right and your whole investment strategy will be right. The hero/zero decision for investors is: from the current level of 1.7 percent, at what level will the 10-year T-bond yield peak and reverse? If the answer is, say, 3 percent, then the recent direction of this correlated trade has much further to go, and investors should stay on the ride. But if the answer is, say, 2 percent, then this correlated trade does not have much further to go, and it will soon be time to get off. To repeat, investment is not complicated, but it is complex. The evolution of the bond yield is not fully analysable or predictable. Still, our assessment is that the rise in the 10-year T-bond yield will meet resistance much closer to 2 percent than to 3 percent. This is because the level of yields is already starting to weigh on the stock market, the financial system, and the real economy. Specifically: The global stock market rally has stalled since mid-February because high-flying growth stocks have been reined back by rising bond yields. Recent margin calls and liquidations in the hedge fund space presage points of fragility in the financial system. Note, there is never just one cockroach. US mortgage applications for home purchases and building permits for new housebuilding appear to be rolling over (Chart I-4). Admittedly, these are just straws in the wind. But straws in the wind can be the first sign of a brewing storm. Chart I-4Are Higher Bond Yields Starting To Weigh On The Housing Market? Are Higher Bond Yields Starting To Weigh On The Housing Market? Are Higher Bond Yields Starting To Weigh On The Housing Market? On a 6-month horizon, fade the underweighting to bonds, tech versus the market, growth versus value, new economy versus old economy, and US versus the euro area correlated trade. Sectors Still Rule The Stock Market World The evolution of the pandemic, the pace of vaccination roll-outs, and the size of fiscal stimuluses have become polarised by region and country, with clear leaders and laggards. This raises the question: are the regions and countries that are winning against the pandemic the investment winners too? For the major stock markets, the answer is an emphatic no. Compared with the US, the euro area is experiencing an aggressive third wave of infections, is lagging in its vaccination roll-outs, and is unleashing much less fiscal stimulus. Yet euro area equities have not been underperforming US equities. Proving that the outperformance and underperformance of the major stock markets has very little to do with what is going on in the local economy. The outperformance and underperformance of the major stock markets has very little to do with what is going on in the local economy. By far the biggest driver of euro area versus US stock market performance is the euro area’s massive underweighting to tech stocks vis-à-vis the US. Hence, the tech sector’s recent travails have boosted the euro area stock market’s relative performance. Similar types of sector skews explain the relative performance of all the major stock markets (Table I-1). For example, developed markets (DM) versus emerging markets (EM) is nothing more than healthcare versus basic resources (Chart I-5). Table I-1The Sector Fingerprints Of The Major Stock Markets The Pareto Principle Of Investment The Pareto Principle Of Investment Chart I-5DM Vs. EM Is Nothing More Than Healthcare Vs. Basic Resources DM Vs. EM Is Nothing More Than Healthcare Vs. Basic Resources DM Vs. EM Is Nothing More Than Healthcare Vs. Basic Resources Exchange rates can also have a bearing on stock market relative performance – though the main transmission mechanism is not through competitiveness, but through the so-called ‘currency translation effect.’ Specifically, the multinationals that dominate the major stock markets have their cost bases diversified across multiple currencies. Hence, for a euro-listed multinational company, a weaker euro doesn’t boost its competitiveness. But it does boost the translation of its multi-currency profits into euros, the currency of its stock market listing. Thereby, the weaker euro boosts its stock price. Don’t Confuse A ‘Stock Effect’ For A ‘Country Effect’ Many people think that there is also a strong ‘country effect’ in stock market selection. For example, if US tech hardware outperforms euro area tech hardware, then this is clearly not a sector effect. It must be to do with a difference between the US and the euro area, meaning a country effect. The truth is more nuanced. Many sectors are now highly concentrated in one or two dominant stocks. US tech hardware is concentrated in Apple while euro area tech hardware is concentrated in ASML. Hence, if US tech hardware is outperforming euro area tech hardware, it is because Apple is outperforming ASML (Chart I-6). Chart I-6Is US Tech Vs. Euro Area Tech A 'Country Effect' Or A 'Stock Effect'? Is US Tech Vs. Euro Area Tech A 'Country Effect' Or A 'Stock Effect'? Is US Tech Vs. Euro Area Tech A 'Country Effect' Or A 'Stock Effect'? Likewise, if euro area pharma is outperforming UK pharma, it is because the dominant euro area pharma stock, Sanofi, is outperforming the dominant UK pharma stock, AstraZeneca (Chart I-7). Chart I-7Is Euro Area Pharma Vs. UK Pharma A 'Country Effect' Or A 'Stock Effect'? Is Euro Area Pharma Vs. UK Pharma A 'Country Effect' Or A 'Stock Effect'? Is Euro Area Pharma Vs. UK Pharma A 'Country Effect' Or A 'Stock Effect'? So, if US tech hardware is outperforming euro area tech hardware, and euro area pharma is outperforming UK pharma, are these ‘country effects’, or are they ‘stock effects’? We would argue that, in truth, they are stock effects. Meaning they have little to do with what is happening in the country of listing, and much more to do with the specifics of the company. For example, if UK pharma is underperforming, it is because AstraZeneca is underperforming. And if AstraZeneca is underperforming, it is more likely to do with the performance of its Covid-19 vaccine than the performance of the UK economy. The problem is that most performance attributions will incorrectly count what are stock effects as country effects. And the more concentrated that sectors become, the more pronounced this error becomes. Yet nowadays, extreme concentration in one or two stocks per sector is the norm rather than the exception. Hence, what appears to be a country effect is, in most cases, a stock effect. What appears to be a country effect is, in most cases, a stock effect. The important lesson is that when allocating to the major stock markets, do not think in terms of regions or countries because the country effect is, in truth, negligible. Think in terms of the sectors and the dominant stocks that you want to own, and the regional and country allocation will resolve itself automatically. On this basis our high-conviction structural position to be overweight DM versus EM simply follows from our high-conviction structural position to be overweight healthcare versus basic resources. In the DM versus EM decision, everything else is largely irrelevant. Candidates For Countertrend Reversals This week’s candidates for countertrend reversal are European autos, and European personal products. The euphoria towards electric vehicles (EVs) has taken European auto stocks to a technically overbought extreme (Chart I-8). Chart I-8European Autos Are Overbought European Autos Are Overbought European Autos Are Overbought Conversely, the euphoria towards economic reopening plays has taken European personal products stocks to a technically oversold extreme (Chart I-9). Chart I-9European Personal Products Are Oversold European Personal Products Are Oversold European Personal Products Are Oversold Our recommended trade is overweight European personal products versus European autos (Chart I-10), setting a profit target and symmetrical stop-loss at 15 percent. Chart I-10Overweight European Personal Products Versus European Autos Overweight European Personal Products Versus European Autos Overweight European Personal Products Versus European Autos   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The exact numbers 20 and 80 are simply indicative of the Pareto Principle rather than set in stone, they could also be 5 and 95, or indeed 5 and 99 as they do not need to sum to 100. Fractal Trading System The Pareto Principle Of Investment The Pareto Principle Of Investment 6-Month Recommendations The Pareto Principle Of Investment The Pareto Principle Of Investment Structural Recommendations The Pareto Principle Of Investment The Pareto Principle Of Investment Closed Fractal Trades The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment Asset Performance The Pareto Principle Of Investment The Pareto Principle Of Investment Equity Market Performance The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment The Pareto Principle Of Investment Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II_7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​

In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,1 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway April 2021 April 2021 On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Highlights Central Bank Expectations: Market expectations of short-term interest rate moves over the next few years are inching higher. The potential for markets to offer a greater bond-bearish challenge to the current highly dovish forward guidance of the major central banks should not be dismissed given the growth-positive mix of expanding global vaccinations and US fiscal stimulus. Global Golden Rule: The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns – a dynamic we have dubbed the “Global Golden Rule of Bond Investing”. Given our expectation that no major developed market central bank will hike rates within the next twelve months, the Global Golden Rule is calling for the recent government bond market laggards to outperform over the next year. Tapering & The Golden Rule: Government bonds in countries where central banks are most likely to begin tapering in 2022 well before considering rate hikes – most notably, the US and Canada – are likely to suffer returns worse than implied by the Global Golden Rule. It is too soon to raise allocations to those higher-beta bond markets. Feature As the first quarter of 2021 draws to a close, fixed income investors are licking their wounds from a rough start to the year. Government bonds across the developed world have absorbed heavy losses as yields have climbed higher, led by US Treasuries which are down -4.0% year-to-date in total return terms. Other markets have also been hit hard, like Canada (-3.9%), Australia (-3.5%) and the UK (-6.3%). The trend in rising yields has been concentrated at longer maturities, with shorter ends of yield curves seeing much smaller moves (Chart 1). Two-year government bond yields are still being pinned down by the dovish forward guidance of the major central banks. The Fed is signaling no rate hikes through at least the end of 2023, while other central banks are sending similar messages on the timing of any potential future rate moves. However, global growth expectations continue to gain upward momentum, fueled by the optimistic combination of expanding COVID-19 vaccinations and aggressive US fiscal stimulus. Real GDP growth is expected to soar to a mid-single digit pace in the US, UK, Canada and even the euro zone - moves heralded by the steady climb of the OECD leading economic indicators and composite purchasing manager indices (Chart 2). Chart 1Rising Yields Reflect Reflation Rising Yields Reflect Reflation Rising Yields Reflect Reflation Chart 2A Bond-Bearish Surge In Global Growth Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Markets will continue to pull forward the timing and pace of the next monetary tightening cycle if those faster above-trend growth forecasts are realized. This will represent a change of “leadership” in the global bond bear market from faster inflation breakevens to increased policy rate expectations helping drive real yields higher. That shift may already be underway according to the ZEW survey of global investor expectations which now shows that the net number of respondents expecting higher short-term interest rates in the US and UK has turned positive (Chart 3). Already, our Central Bank Monitors for the US, Canada and Australia (Chart 4) have climbed back to neutral levels suggesting that easier monetary policy is no longer required. Similar trends can be seen to a lesser extent in the UK, euro area and even Japan (Chart 5). These moves are already coinciding with increased cyclical upward pressure on global bond yields, even without any change in dovish central bank guidance alongside ongoing buying of government bonds via quantitative easing programs. Chart 3Shifting Expectations For Policy Rates? Shifting Expectations For Policy Rates? Shifting Expectations For Policy Rates? Chart 4Diminishing Need For Easy Monetary Policy Here Diminishing Need For Easy Monetary Policy Here Diminishing Need For Easy Monetary Policy Here   Chart 5Easy Policy Still Required Here Easy Policy Still Required Here Easy Policy Still Required Here How will a trend of rising short-term interest rate expectations translate into future expected returns on government bonds? For that, we revisit a framework temporarily set aside during the pandemic era of crisis monetary policies – the Global Golden Rule (GGR) of bond investing. An Update Of The Global Golden Rule, By Country In September 2018, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.” This was an extension of a framework introduced by our sister service, US Bond Strategy, that links US Treasury returns (versus cash) to changes in the fed funds rate that were not already discounted in the US Overnight Index Swap (OIS) curve.1 The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. We discovered that relationship also held in other developed market countries. Thus, we now had a framework to help project expected bond returns simply based on a view for future central bank interest rate moves versus market expectations.2 Specific details on the calculation of the Global Golden Rule can be found in those original 2018 papers. In the following pages, we present the latest results of the Global Golden Rule for the US, Canada, Australia, the UK, the euro area and Japan. The set-up for the chart shown for each country is the same. We show the 12-month policy rate “surprise”, defined as the actual change in the central bank policy rate over the preceding 12-months versus the expected 12-month change in the policy rate from a year earlier extracted from OIS curves (aka our 12-month discounters). We then compare the 12-month policy rate surprise to the annual excess return over cash (treasury bills) of the Bloomberg Barclays government bond index for each country. We also show the 12-month policy rate surprise versus the 12-month change in the government bond index yield. The very strong historical correlation between those latter two series is the backbone of the Global Golden Rule framework. After that, we present tables showing expected yield changes and excess returns for various maturity points, as well as the overall government bond index, derived from the Global Golden Rule regressions. The expected change in yield is derived from regressions on the policy rate surprises, with different estimations done for each maturity point. In the tables, we show the results for different scenarios for changes in policy rates. For example, the row in the return tables called “1 rate hike” would show the expected yield changes and excess returns if the central bank for that particular country lifts the policy interest rate by +25bps over the next 12 months. This allows us to pick the scenario(s) that most closely correlate to our own expectation for central bank actions, translating that into government bond return expectations. Global Golden Rule: US Chart 6UST Selloff Akin To A Hawkish Surprise UST Selloff Akin To A Hawkish Surprise UST Selloff Akin To A Hawkish Surprise The Golden Rule would have underestimated the losses realized by US Treasuries over the past year (-4.5%), as negative excess returns over cash typically occur when the Fed is more hawkish than expectations – an outcome that did not occur (Chart 6). The trailing 12-month policy rate surprise for the US is currently zero, as last year’s massively dovish rate cuts have rolled off. The US OIS curve now discounts only 5bps of interest rate increases over the next 12 months, a period that runs to the end of first quarter of 2022. This is in line with the Fed’s guidance that no rate hikes will take place before the end of 2023. Our base case is the “Flat” scenario shown in Table 1 and Table 2, with the Fed keeping the funds rate unchanged near 0% for the next twelve months – a very modest “dovish” surprise. This produces a Golden Rule forecast of the overall US Treasury index yield falling -2bps that generates a total return of +1.1%. This is essentially a coupon-clipping return equivalent to the current index yield. Table 1US: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 2US: Expected Changes In Treasury Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Canada Chart 7Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian Bond Selloff Worse Than Implied By Golden Rule Canadian government bonds have sold off smartly over the past 12 months, delivering an excess return over cash of -2.8%. That is a smaller loss, however, compared to other developed economy government bond markets. The Canadian OIS curve did not move as aggressively to price in rate cuts last year, so the rapid pace of Bank of Canada (BoC) easing that was actually delivered constituted a modest “dovish surprise” that helped mute Canadian bond losses to some degree (Chart 7). The trailing 12-month policy rate surprise for Canada is +37bps (a dovish surprise), but rate expectations are more aggressive on forward basis. The Canadian OIS curve now discounts +28bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This stands out as the highest such figure among the countries discussed in this report. This is likely due to the relatively less dovish messaging from BoC officials who have hinted that QE could be tapered sooner than expected if the economy outperforms the BoC’s forecasts for 2021. Our base case is the “Flat” scenario shown in Table 3 and Table 4, with the BoC keeping the policy interest rate at 0.25% for the next twelve months. This produces a Golden Rule forecast of a decline in the overall Canadian government bond index yield of -12bps, delivering a projected total return of +1.69%. That return may turn out to be overly optimistic if the BoC does indeed begin tapering QE later this year. Table 3Canada: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 4Canada: Expected Changes In Government Bond Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Australia Chart 8Australian Bonds Acting Like The RBA Was Hawkish Australian Bonds Acting Like The RBA Was Hawkish Australian Bonds Acting Like The RBA Was Hawkish Australian government bonds have delivered a negative excess return over cash of -3.6% over the past year (Chart 8). This underperformed the projection from the Golden Rule, as the Reserve Bank of Australia (RBA) was not more hawkish than market expectations. The central bank actually delivered a dovish surprise in 2020, not only cutting policy rates dramatically but starting up a bond-buying QE program and instituting yield curve control to cap 3-year bond yields. The trailing 12-month policy rate surprise for Australia is zero, as last year’s massively dovish surprise rate cuts have rolled off. The Australia OIS curve now discounts only 7bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This is in line with the RBA’s highly dovish guidance suggesting that there will be no change to current policy settings until Australian wage growth picks up to the 3% level consistent with the RBA’s 2-3% CPI inflation target. The central bank does not expect that to occur before 2023. We agree with dovish guidance from the RBA, thus our base case is the “Flat” scenario shown in Table 5 and Table 6, with the RBA keeping the Cash Rate unchanged at 0.1% for the next twelve months. This generates a Golden Rule forecast of an -5bps decline in the overall Australian government bond index yield, producing a total return projection of +1.4%. Table 5Australia: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 6Australia: Expected Changes In Government Bond Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: UK Chart 9A UK Gilt Selloff Without A Hawkish BoE A UK Gilt Selloff Without A Hawkish BoE A UK Gilt Selloff Without A Hawkish BoE UK Gilts underperformed the Golden Rule forecast over the past 12 months, delivering a negative excess return over cash of –5.1% even with the Bank of England (BoE) not delivering any hawkish surprise versus market expectations (Chart 9). The trailing 12-month policy rate surprise for the UK is currently zero. The UK OIS curve now discounts only 5bps of interest rate increases over the next 12-months, a period that runs to the end of first quarter of 2022. This is in line with the BoE’s guidance that no monetary tightening will take place until there is clear evidence that the excess capacity created by the pandemic shock is clearly being absorbed. Yet while the BoE has still left the door open to moving to a negative policy rate if needed, markets are not discounting any such move. Our base case is the “Flat” scenario shown in Table 7 and Table 8, with the BoE keeping the Bank Rate unchanged at 0.1% for the next twelve months. This produces a Golden Rule forecast of the overall UK Gilt index yield falling -2bps that generates a total return of +1.0%. This is a return only slightly above the current index yield. Table 7UK: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 8UK: Expected Changes In Gilt Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Germany Chart 10Even Bunds Acting Like ECB Is "Hawkish" Even Bunds Acting Like ECB Is "Hawkish" Even Bunds Acting Like ECB Is "Hawkish" German government bonds have produced an excess return over cash of -1.6% over the past year. There was no surprise from the European Central Bank (ECB) during that time relative to market expectations (Chart 10), so that negative return reflected the modest rise in German bond yields on the back of improving global growth. The trailing 12-month policy rate surprise for Germany (and the overall euro area) remains stuck near zero, as has been the case since the ECB cut its deposit rate below zero and instituted QE back in 2016. The euro area OIS curve now discounts only -4bps of interest rate cuts over the next 12 months, a period that runs to the end of first quarter of 2022. This is in line with the ECB’s guidance that rates will be kept unchanged until at least 2023, as the central bank’s projections call for euro area inflation to not climb above 1.5% - below the ECB’s 2% target – through 2023. The OIS curve is discounting a small probability that the ECB could be forced to deliver a small rate cut given the degree of the euro area inflation undershoot. Our base case, however, is that the ECB will keep rates steady over the next 12 months (and likely for a few more years after that). Thus, the “Flat” scenarios shown in Table 9 and Table 10 are most relevant, with the German government bond index yield rising +2bps according to the Golden Rule. This produces a total return projection of -0.6%. Table 9Germany: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 10Germany: Expected Changes In Bund Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Global Golden Rule: Japan Chart 11JGBs Bucking The Global "Hawkish" Selloff JGBs Bucking The Global "Hawkish" Selloff JGBs Bucking The Global "Hawkish" Selloff Japanese government bonds (JGBs) have delivered an excess return versus cash of -0.8% over the past twelve months (Chart 11). Although it may sound unusual for Japan, there was actually a tiny “hawkish” surprise as the Bank of Japan (BoJ) kept policy rates steady over the past year even as markets had priced in a possibility of a small rate cut in response to the COVID-19 growth shock. Admittedly, the Golden Rule framework is poorly suited to project Japanese bond returns. The Bank of Japan (BoJ) has been unable to lift policy rates for many years, while they have instituted yield curve control on 10-year JGBs since 2016, anchoring yields near zero. With no variability on policy rates or bond yields, a methodology that links bond returns to unexpected policy interest rate changes will have poor predictive power. The Japan OIS curve now discounts -5bps of interest rate cuts over the next 12 months, a period that runs to the end of first quarter of 2022. The BoJ has not ruled out the possibility of a small rate cut sometime in the next few months, as Japanese inflation remains far below the 2% BoJ target. Our base case is the “Flat” scenarios shown in Table 11 and Table 12, with the BoJ keeping policy rates unchanged near 0% for the next twelve months. That generates a Golden Rule forecast of a +5bp increase in the Japanese government bond index yield, with a total return projection of -0.4%. This would be consistent with the BoJ producing a small hawkish “surprise” by not cutting rates deeper into negative territory. Table 11Japan: Government Bond Index Total Return Forecasts Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Table 12Japan: Expected Changes In JGB Yields Over The Next 12 Months Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Investment Implications Of The Global Golden Rule Projections Among all the scenarios laid out above, our base case has been that no change in policy rates should be expected over the next 12 months in any of the countries. This fits with our view that central banks will be reluctant to consider any changes to the current dovish forward guidance on future rate hikes until there is clear evidence that the global economy has moved beyond the pandemic. That means taking some near-term inflation risks given the very robust pace of growth expected over the rest of 2021. In Table 13, we rank all the return projections generated by the Global Golden Rule for the “Flat” scenarios on policy rates over the next year. Returns are shown both in local currency terms and in USD-hedged terms. Table 13Government Bond Index Total Return Forecasts Over The Next 12 Months Assuming Policy Rates Remain Unchanged Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing The return rankings are a mirror image of the performance seen year-to-date, with the “higher beta” bond markets (Canada, Australia and the US) outperforming the more defensive low-yielding markets (the UK, Germany and Japan). Returns are projected to be moderate, however, with Canada leading the way both unhedged (+1.69%) and currency hedged (+1.73%). The return rankings excluding the +10-year maturity buckets of the government bond indices are shown in Table 14. We present these to allow a more “apples to apples” comparison of the six regions shown, as the UK index has a huge weighting in the +10-year bucket while there is no +10-year benchmark for Australia. On this basis, Australia stands out as having the best Global Golden Rule generated return projections, both unhedged (+1.44%) and USD-hedged (+1.66%).3 Table 14 Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing These return rankings run counter to our current recommended country allocation: underweight the US, overweight Germany and Japan and neutral the UK, Canada and Australia. We still believe there is more near-term upside for global bond yields, led by US Treasuries, thus it is too soon to begin to position for the results projected by the Global Golden Rule. There is one other factor that leads us to interpret the results cautiously – the likelihood that some central banks will begin tapering their bond purchases within the next 12 months. Our expectation is that the Fed will begin to signal a need to slow the pace of its QE bond buying in the fourth quarter of this year, with actual tapering beginning in Q1 of 2022. The BoC is likely to follow suit shortly thereafter. Thus, the Fed and BoC will begin tapering within the 12-month forecasting window of the Global Golden Rule. The RBA and BoE will debate a need to taper later in 2022 – beyond that 12-month window – while the ECB and BoJ will maintain their current pace of bond buying until at least the end of 2022. From the point of view of bond markets, tapering by the Fed and BoC will likely feel as if those central banks were actually delivering rate hikes. Bond yields will likely rise by more than projected by the Global Golden Rule in the “Flat” scenarios highlighted earlier. Quantitative models that attempt to translate QE into interest rate changes, so-called “shadow rates”, show that the Fed’s QE bond buying over the past year has been equivalent to nearly 250bp of additional Fed rate cuts after the funds rate was slashed to 0% (Chart 12). Thus, when the Fed begins to taper QE, it will conceptually be as if the Fed started a rate hike cycle with the starting point of a fed funds rate at minus -2.5%. When looking at the historical correlation of changes in the US shadow rate and US Treasury yields, the +40bps rise in the Treasury index yield over the past 12 months is equivalent to roughly a 100bp increase in the shadow fed funds rate (Chart 13, top panel). That would line up with a fairly aggressive pace of Fed tapering when looking at the correlation of changes in the shadow rate to changes in the size of the Fed balance sheet (middle panel). Chart 12"Shadow Policy Rates" Are Below 0% "Shadow Policy Rates" Are Below 0% "Shadow Policy Rates" Are Below 0% Chart 13UST Yields Discount A Lot Of Fed Tapering UST Yields Discount A Lot Of Fed Tapering UST Yields Discount A Lot Of Fed Tapering US Treasury yields have been rising for more fundamental reasons like improving growth expectations alongside rising inflation expectations. If the Fed is forced to signal a tapering of QE later this year because that robust growth outlook comes to fruition, it is a stretch to think that Treasury yields will not see additional upward pressure. Thus, we are sticking with our current country allocations, despite the message from our Global Golden Rule. US Treasury returns may look more like the “1 rate hike” or “2 rate hikes” scenarios shown in Table 1 when the Fed begins tapering early in 2022. The same goes for Canadian bond yields once the BoC moves to taper soon after the Fed, as we expect, which is why we are keeping Canada on “downgrade watch.” Bottom Line: The Global Golden Rule is calling for the recent government bond market laggards to outperform over the next year if central banks keep rates on hold. Government bonds in countries where central banks are most likely to begin tapering in 2022 well before considering rate hikes – most notably, the US and Canada – are likely to suffer returns worse than implied by the Global Golden Rule. It is too soon to raise allocations to those higher-beta bond markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcarearch.com. 2 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25, 2018, available at gfis.bcaresearch.com. 3 Note that in Table 14, we rescale the other maturity buckets after removing the +10-year bucket. The index returns are presented as a market-capitalization weighted combination of the expected returns of the remaining maturity buckets. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Revisiting Our Global Golden Rule Of Bond Investing Revisiting Our Global Golden Rule Of Bond Investing Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns