Inflation/Deflation

Executive Summary The Fed will continue to hike rates at a time when global trade is contracting. Earlier this week, Fed Chairman Jerome Powell reiterated that the Fed will not hesitate to hike rates until core consumer price inflation gets closer to 2%. Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Besides, according to Powell, US financial conditions are not yet at a level that is consistent with inflation coming down substantially. China will stick to its dynamic zero-COVID policy this year. The economy will continue to underwhelm as the magnitude and nature of stimulus measures announced thus far are not adequate to produce a recovery. Industrial metal prices and global material stocks are at risk of gapping down. Play these markets on the short side. Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Bottom Line: It is still dangerous to bottom fish in global equities and risk assets in general. The US dollar has more upside. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Feature The risks to global and EM risk assets are still skewed to the downside. Although investor sentiment on global equities has soured of late, we do not think global or EM equities have made a bottom, and the US dollar has not yet reached an apex. Consequently, absolute-return investors should stay defensive, and global equity portfolios should continue to underweight EM stocks. The Fed and Equities Are Still On A Collision Course Earlier this week, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation”… “We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Chart 1US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now Chart 1 shows the average of core median CPI, core trimmed-mean CPI and core sticky CPI, which are better indicators of genuine inflationary pressures because they are less affected by outliers. Even though core CPI inflation ticked down in April, other core measures such as core median CPI, core trimmed-mean CPI and core sticky CPI continued to rise. These core inflation measures are not likely to ease back to 2% unless economic growth falls below its potential. In his same speech, Chairman Powell also asserted: “We will go until we feel like we are at a place where we can say, ‘Yes, financial conditions are at an appropriate place. We see inflation coming down.’ We will go to that point, and there will not be any hesitation about that.” This means that US financial conditions have not yet tightened enough for the Fed to back down on its hawkishness. Finally, we have been arguing that a wage-price spiral has developed in the US as the labor market has become very tight (Chart 2, top panel). Wages and unit labor costs have been surging. Unit labor costs are the most important driver of US core CPI (Chart 2, bottom panel). Therefore, it will be impossible for the Fed to bring down core inflation toward 2% without a retrenchment in the labor market, i.e., layoffs. Rising unemployment will in turn weigh on household income growth and consumption. Chart 2The US Labor Market Is Very Tight And Wage Growth Is Accelerating The US Labor Market Is Very Tight And Wage Growth Is Accelerating The US Labor Market Is Very Tight And Wage Growth Is Accelerating The cost of borrowing for companies is rising globally, and these periods often coincide with equity selloffs. Notably, surging US high-yield ex-energy corporate bond yields herald lower US share prices ahead (Chart 3, top panel). Similarly, rising EM corporate bond yields foreshadow a further decline in EM ex-TMT share prices (Chart 3, bottom panel). Chart 3Rising Corporate Bond Yields Are Bearish For Stocks Rising Corporate Bond Yields Are Bearish For Stocks Rising Corporate Bond Yields Are Bearish For Stocks On the whole, the Fed and many other central banks will be hiking interest rates at a time when global trade volumes are contracting in H2 2022. As discussed in our report A Whiff Of Stagflation? US and EU imports of consumer goods are set to shrink following the pandemic boom. Chart 4Global Export/Manufacturing Are Heading Into Contraction Global Export/Manufacturing Are Heading Into Contraction Global Export/Manufacturing Are Heading Into Contraction Meantime, rolling lockdowns and extremely weak income growth are depressing domestic demand in China. High food and energy prices as well as rising interest rates are weighing on EM ex-China consumption. The sharp underperformance of global cyclicals equities versus global defensive sectors corroborates our expectation that global manufacturing activity will contract (Chart 4). The trade-weighted US dollar typically benefits from both Fed hikes and a global trade slump. As long as the Fed is hawkish and global exports are contracting, the greenback will continue to appreciate. For now, the US dollar remains in a strong position for further appreciation, especially versus EM currencies (Chart 5). Consistently, the selloff in broad EM risk assets is not yet over.  Chart 5EM Currencies: More Downside EM Currencies: More Downside EM Currencies: More Downside A major reversal in the trade-weighted dollar will be a signal that the global macro backdrop is improving and that global share prices and EM risk assets are bottoming. Bottom Line: Although equities have become oversold and investor sentiment is depressed, any rebound will prove to be short lived. The Fed will continue to hike rates at a time when global trade is about to shrink. The global/EM equity selloff has further to run. China: Ordinary Stimulus Despite Extraordinary Conditions Only one thing is currently certain in China: authorities are committed to the dynamic zero-COVID policy. However, most experts outside China believe that it will be very difficult to wholly limit the spread of the easily transmissible Omicron variants, even with such stringent mainland containment policies. As a result, rolling lockdowns are the most likely scenario for China’s regions and cities in 2022. These lockdowns will depress household income, confidence and consumption. Private business investment and hiring will also tank. Have authorities provided enough stimulus to support a recovery in H2 2022? We do not think so. Chinese stimulus has so far been ordinary in nature and in magnitude. Policy easing will likely prove to be insufficient to lift the economy out of the current extraordinary slump. First, Chinese exports are set to shrink in H2 as US and EU consumption of consumer goods revert to their pre-pandemic trend. Demand from EM will remain weak. Second, rising unemployment and under-employment is hindering household income. Generous cash transfers are needed to offset this hit to income. Not only did aggregate retail sales collapse in April, but online sales of goods and service also plunged (Chart 6). It is hard to imagine that private businesses will be investing when consumer spending and exports are weak. Our proxies for the marginal propensity to spend for households and enterprises continue to fall (Chart 7). Chart 6China: Even Online Retail Sales Are Shrinking China: Even Online Retail Sales Are Shrinking China: Even Online Retail Sales Are Shrinking Chart 7China: Household And Enterprise Propensity To Spend Have Been Declining China: Household And Enterprise Propensity To Spend Have Been Declining China: Household And Enterprise Propensity To Spend Have Been Declining   Critically, China’s credit impulse, excluding government bond issuance, remains in negative territory (Chart 8). Third, China’s property market is frail. Despite modest policy easing for the real estate market, sentiment among home buyers and developers remains downbeat. Given that the housing sector faces structural headwinds, odds are that buyers and developers might not react to the modest property market easing that authorities have so far provided. It is worth noting that Chinese property stocks seem to have had a structural breakdown, and offshore corporate bonds of real estate developers remain in a bear market (Chart 9). These market patterns corroborate that China's housing market has experienced a structural breakdown. Chart 8Chinese Stimulus Has So Far Been Tame Chinese Stimulus Has So Far Been Tame Chinese Stimulus Has So Far Been Tame Chart 9Chinese Property Market Has Experienced A Structural Breakdown Chinese Property Market Has Experienced A Structural Breakdown Chinese Property Market Has Experienced A Structural Breakdown   Finally, even though infrastructure spending is being ramped up, it will prove to be insufficient for the economy to recover from a deep slump. Local governments are facing a major financing shortfall. Land sales – which make up about 40% of local government revenues – have dried up. This will hinder local governments’ ability to finance infrastructure projects. As to Chinese equities, internet/platform stocks have become oversold. However, their long-term outlook remains dismal. As we have been arguing since late 2020, the fundamental case for their de-rating remains intact. This week’s meeting between government officials and technology companies has not produced any positive news. Although the tone from authorities was more balanced, they did not offer any relief from already imposed regulations. Chart 10Implications Of China's Common Prosperity Policies Implications Of China's Common Prosperity Policies Implications Of China's Common Prosperity Policies Looking forward, implementing common prosperity policies will be the primary objective of the Communist Party in the coming years. These policies will assure that labor’s share of income will rise further at the expense of corporate profits. Chart 10 demonstrates that the share of labor in national income has been rising since 2011. Conversely, the share operating profits peaked in 2011 and has dropped to a 30-year low. These dynamics will persist as income will continue to be redistributed from shareholders to labor in the majority of industries/companies in China. This is an unfriendly outlook for shareholders, especially foreign ones. Bottom Line: Chinese policy stimulus has so far been insufficient. The economy is in a deep slump, and share prices remain at risk of further decline. Short Industrial Metals And Material Stocks Chart 11Chinese Imports Of Metals Was Shrinking In 2021 Chinese Imports Of Metals Was Shrinking In 2021 Chinese Imports Of Metals Was Shrinking In 2021 Industrial metals’ resilience last year in the face of shrinking Chinese import volumes was unusual (Chart 11). This resilience was probably due to robust DM demand for goods, supply bottlenecks and investors buying commodities as an inflation hedge. As we elaborated in the April 28 report, risks to industrial metals are skewed to the downside. This is despite the fact that agriculture prices will likely rise further, and energy prices will remain volatile due to the geopolitical situation. We continue to recommend investors underweight/short materials stocks and industrial metals for the following reasons: It is ill-advised to play the US inflation story by being long industrial metals and materials stocks. As shown in Chart 2 above, US unit labor costs are driving core inflation, not industrial metals. China accounts for 50-55% of global industrial metal consumption, and since early 2021 the key risk in China has been decelerating demand/deflation not inflation. In fact, commodities have become a crowded hedge against inflation and a global growth slowdown poses a substantial risk to industrial metals. Chart 12 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding energy). Chart 12Chinese Material Stocks Are Signaling Trouble For Global Materials Chinese Material Stocks Are Signaling Trouble For Global Materials Chinese Material Stocks Are Signaling Trouble For Global Materials When share prices of customers are falling, equity prices of suppliers will likely follow. Chart 13 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed raw material prices to two standard deviations above this long-term trend. Chart 13Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 13 does not include energy, gold and semi-precious metals. Finally, shrinking global trade volumes are also negative for raw materials. The average of AUD, NZD and CAD points to lower industrial metal prices (Chart 14). Chart 14Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Commodity Currencies Are Signaling Lower Commodity Prices Chart 15Bearish Technical Patterns: BHP Share Price And Copper Bearish Technical Patterns: BHP Share Price And Copper Bearish Technical Patterns: BHP Share Price And Copper The share price of BHP, the world’s largest mining company, has put in a major top and is now gapping down (Chart 15, top panel). Copper prices have broken below their 200-day moving average that served as a support in the past 12 months (Chart 15, bottom panel). These market profiles point to more downside. We continue to recommend that investors play this theme in the following ways: Short copper or short copper / long gold; Short global materials / long global industrials; Short ZAR / long USD. Also, we downgraded Brazil early this week  partly due to expectations of lower iron ore prices and souring investor attitude toward commodity plays in general. Investment Conclusions Global and EM equities have entered a capitulation phase. It is still dangerous to bottom fish in global equities and risk assets in general. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. The US dollar has more upside. Continue shorting the following EM currencies versus the USD: ZAR, PLN, HUF, COP, PEN, PHP and IDR. As we discussed in a recent report, we are approaching a major buying opportunity in EM local currency bonds. However, the US dollar needs to peak for that to transpire. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally China’s food price inflation accelerated in April. The rising cost of global agricultural goods and domestic COVID-related disruptions in the supply-chain contributed to a sharp bump in food prices last month. China is not overly reliant on food imports. The country is also well stocked with grain reserves and should weather ongoing global food supply shortages, particularly wheat, better than most emerging economies.  However, China will still be impacted by escalating prices of global agricultural products and energy. Some imported goods (e.g. soybeans and related products) that China relies on, coupled with higher energy costs and a bottoming in China’s pork prices, will continue to push up food prices and headline inflation. Higher reading in headline inflation will not change the direction of the PBoC’s monetary policy. However, more expensive food will dampen Chinese households’ spending power on non-food consumer goods, especially as income growth slows. The food and beverage sector in China’s onshore stocks will benefit from higher food costs. We are initiating a new trade: long domestic consumer staples/broad A-share market. CYCLICAL RECOMMENDATIONS (6 - 18 MONTHS) INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG DOMESTIC CONSUMER STAPLES/BROAD A-SHARE MARKET 05/18/2022     Bottom Line: Despite China’s solid self-sufficiency in food supplies, its food price inflation is not immune from the mounting prices of global agricultural products.   Is China’s Food Price Inflation Transitory? The food component of China’s consumer price index (CPI) increased by 0.9% in April compared with the previous month, a sharp reversal from a 1.2% month-over-month decline in March. Higher food and energy prices pushed headline CPI to 2.1% in April, the fastest year-on-year growth since August 2020. China is not overly reliant on food imports and has abundant grain reserves.  The country is in a better position to weather ongoing global supply shortages in grain compared with other emerging economies, such as the Middle East and North Africa. Moreover, agricultural product prices in China have been structurally higher than those traded in the global commodity market. Large margins in China’s bulk agricultural pricing provide a cushion from escalating global food prices. Nonetheless, China remains at risk for higher food prices this year. Elevated oil prices and the war in Ukraine will further lift the price of fertilizers, adding to input costs for agricultural products. A strong USD will add to the price of USD-denominated commodity imports, particularly soybeans. In addition, China’s domestic pork price may have reached its hog cycle bottom and will pick up in the second half of this year. Food Prices Are Driving Up Inflation China’s headline CPI accelerated to 2.1% in April, on a year-on-year basis, from 1.5% in the previous month. Even though pork prices plunged by 33% in April from a year ago, food prices grew by 1.9% and have been boosted by a jump in the cost of fresh food, such as vegetables (+24% year-on-year), fruit (+14%) and eggs (+12%). Prices in other food categories, such as grains and edible oil, also rose, albeit more modestly (Chart 1A and 1B). Chart 1ALarge Jump In Fresh Food Prices In April Large Jump In Fresh Food Prices In April Large Jump In Fresh Food Prices In April Chart 1BOther Food Prices Also Picked Up, But More Modestly Other Food Prices Also Picked Up, But More Modestly Other Food Prices Also Picked Up, But More Modestly China’s strict COVID-19 containment measures have had a broad-based impact on food supplies. Mobility restrictions, roadblocks and risk-averse truck drivers introduced significant challenges in food supplies and transportation. Lockdowns in some large urban areas also led to panic buying and stockpiling among consumers, pushing up demand. Chart 2Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Meanwhile, higher global food and energy prices have likely both directly and indirectly contributed to food price inflation in China. The UN Food and Agriculture Organization (FAO) Food Price Index in April this year leapt to its highest level since its inception in 1990; it is 30% higher than last year and nearly double from its trough in mid-2020. Although price increases in China’s domestic agricultural products have been more moderate, the country’s agricultural wholesale prices have jumped by 10% from a year ago (Chart 2). Bottom Line: Food accounts for about 20% of China’s CPI basket (Chart 3).  Climbing food, along with energy, prices are driving up China’s headline inflation. Chart 3Food Accounts For 20% Of Chinese Household Budgets Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? China Is In A Good Position To Weather Global Food Supply Shocks … Chart 4Ex-China Food Inventories Haven’t Been Built Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? China is well stocked with food reserves and does not rely on imports for most of its agricultural supplies. Thus, the country should weather ongoing global shortages in the food supply better than most emerging economies (Chart 4).  China’s food inventories are significantly higher than levels in the 2006-2008 and 2010-2012 global food price hikes (Chart 5). The nation’s inventories have been steadily building up in the past decade to avert potential food supply shortages. Corn and rice stocks are sufficient to cover consumption for nearly three quarters of a year and wheat stocks are at nearly a year’s worth of consumption. Chart 5China Has Been Building Up Inventories To Buffer Against Supply Shortfalls Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Chart 6China Is Not Overly Dependent On Ag Imports Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Furthermore, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 6). The country is self-sufficient in supplying rice, wheat, and corn, three major staples in China’s grain consumption basket. Less than 5% of China’s total consumption of the three staple grains comes from imports. Bottom Line:  China is well stocked with agriculture products and is not overly dependent on imports for its food supplies. … But Not Immune To Food Price Hikes Worldwide Chart 7Ag Products Are Traded At Higher Prices In China Than In The Global Market Ag Products Are Traded At Higher Prices In China Than In The Global Market Ag Products Are Traded At Higher Prices In China Than In The Global Market Rising global agricultural and energy prices could still push up the country’s food price inflation. In USD terms, prices of China’s domestic agricultural products have been structurally higher than those traded on global commodity markets (Chart 7). The government heavily regulates and subsidizes its agricultural procurement prices as an encouragement to domestic farmers.  When global food supply shocks sharply pushed up agricultural prices worldwide, China’s domestic agricultural prices, with their large buffer versus global food prices, rose more moderately.  Nonetheless, China’s domestic food prices are not insulated from worldwide price hikes. China is facing higher inflation in food prices this year for the following reasons: Pork prices, which account for 13% of China’s CPI food basket, have likely bottomed. Although pork prices remain in a deep contraction year-over-year, they rebounded sharply in April on a month-on-month basis (Chart 8). The number of sows peaked in mid-2021 and has been declining for the past 10 consecutive months. Falling sow numbers have historically led to rising pork prices (Chart 9).   Chart 8Pork Prices May Have Bottomed Pork Prices May Have Bottomed Pork Prices May Have Bottomed Chart 9Pork Prices Will Likely Increase In 2H22 Is China’s Food Price Inflation Transitory? Is China’s Food Price Inflation Transitory? Nearly 90% of China’s soybean consumption relies on imports, making the country vulnerable to external price fluctuations. Soybean prices have jumped sharply this year. A stronger USD will also add to the price of USD-denominated commodity imports. About 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry, which means higher soybean prices will indirectly lead to rising pork prices by boosting input costs. Given that pig output is approaching its cyclical bottom, an increase in pig livestock would mean more demand for soybeans.  Chart 10Edible Oil Prices Reached Their Highest In Decades Edible Oil Prices Reached Their Highest In Decades Edible Oil Prices Reached Their Highest In Decades Growing prices in soybeans and corn will lift the cost of cooking oil, which represents about 8% of China’s food CPI basket (Chart 10). Ukraine supplies 30% of China’s corn imports, and Russia and Ukraine together account for nearly 20% of China’s soybean oil imports. China ramped up corn imports from Ukraine through March despite the war and snapped up large volumes of US corn in April after supplies from Ukraine were cut off. Nonetheless, prices of soybeans and corn will likely remain elevated with no end in sight to the Russia-Ukraine war and supply shortages globally. In addition, as global travel becomes more popular and oil prices remain elevated, the demand for corn-based ethanol, which is blended with gasoline, will also expand. Wheat prices will continue to experience upward pressure in the global market, mainly due to reduced production and exports from Ukraine and Russia (these countries account for 30% of world’s wheat exports). The World Bank forecasts that wheat will be 40% more expensive this year, reaching an all-time high in nominal terms.1 Although China is about 96% self-sufficient in wheat, the upsurge in global prices has boosted China’s domestic cost for wheat; it climbed by 15% in May from a year ago (Chart 11). Higher shipping and input costs, especially for fertilizers, will exacerbate the upside price pressures on agricultural goods. China is the world’s largest exporter of phosphate fertilizer, but its domestic fertilizer prices are heavily subsidized and much cheaper than exported ones (Chart 12). However, the domestic cost of fertilizer will likely follow the lead of rising global prices for fertilizers and agricultural products. Chart 11Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chart 12China's Domestic Fertilizer Prices Will Likely Trend Up China's Domestic Fertilizer Prices Will Likely Trend Up China's Domestic Fertilizer Prices Will Likely Trend Up The relationship between agricultural prices and the dollar broke down early last year (Chart 13). Historically, a strong USD would weigh down agricultural prices by encouraging ex-US producers to raise exports and boost global supplies. However, the COVID pandemic and war in Ukraine have triggered a global surge in government controls on food exports. Such broad enforcement of protectionist measures will continue to exacerbate worldwide inflationary pressures on food. Chart 13The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down Bottom Line: China’s food prices face upward pressure. Strengthening global prices in a wide range of agricultural products, coupled with higher energy costs and a bottoming in China’s pork prices, will all contribute to higher food price inflation in the country. Investment Conclusions Chart 14Core CPI Remains Subdued Core CPI Remains Subdued Core CPI Remains Subdued Food price inflation should not constrain the PBoC from further easing monetary policy. As mentioned in previous reports, China’s monetary policy framework has shifted away from headline CPI and has been anchored in core CPI, which has remained subdued  (Chart 14). However, China’s accelerating food and energy prices, as household income growth is slowing, will lower households’ purchasing power and curb their demand for non-food consumer goods and services.  While China’s overall consumption and economy will suffer from higher food price inflation, soaring food prices will help to widen the profit margins among food processing firms (Chart 15).  Furthermore, food and beverage companies in China’s onshore equity market have one of the highest ROAs and the lowest financial leverages (Chart 16). We are initiating a new trade: long Chinese onshore consumer staples/short broad A-share market. Chart 15Long Chinese Onshore Consumer Staples... Long Chinese Onshore Consumer Staples... Long Chinese Onshore Consumer Staples... Chart 16...As The Sector Will Benefit From Rising Food Prices ...As The Sector Will Benefit From Rising Food Prices ...As The Sector Will Benefit From Rising Food Prices   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1     The World Bank’s Commodity Markets Outlook Report, April 2022.     Strategic Themes Cyclical Recommendations

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 17 at 9:00 AM EDT, 14:00 PM BST, 15:00 PM CEST and May 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Executive Summary Global inflation will peak sometime in the next few months, a process that has likely already begun in the US. This will give policymakers some breathing room to turn less hawkish, a more credible stance given softening global growth momentum and increased financial market volatility. Our Global Golden Rule of Bond Investing suggests that overall government bond returns should turn positive over the next year, but with widening divergences across countries for our base case scenarios. Projected government bond return expectations over the next 12 months look most attractive in Australia, Germany and the UK – where far too many rate hikes are priced in – compared to the US, where the Fed is more likely to follow through on most, but not all, discounted rate increases. Japan has the lowest expected returns, and the defensive properties of “low-beta” JGBs will be less necessary with global yield momentum set to peak in the latter half of 2022. Our Global Golden Rule Base Case Scenarios For The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Bottom Line: The return expectations over the next year stemming from our Global Golden Rule suggest the following country allocation recommendations in global government bond portfolios: maintain overweights in Australia, Germany and the UK, stay underweight the US and neutral Canada, but downgrade Japan to underweight. Feature Chart 1A Pause In The Global Bond Bear Market A Pause In The Global Bond Bear Market A Pause In The Global Bond Bear Market Global bond markets may finally be showing signs of settling down after a painful period of rising yields and high volatility. Government bond yields across the developed economies have fallen substantially over the past week as equity and credit markets have sold off, in a typical risk-off response to increased concerns over global growth momentum. For example, benchmark 10-year government yields have fallen by -32bps both the US and UK, -25bps in Germany and -22bps in Canada since the cyclical intraday high was reached on May 9. These moves are modest in the context of the cyclical bond bear market, with the Bloomberg Global Treasury index still down -12.1% year-to-date and -14.4% on a year-over-year basis (Chart 1). That painful selloff has been driven by expectations of intense monetary tightening in response to surging global inflation. However, last week’s release of US Consumer Price Index data for April confirmed that US goods inflation has peaked, a trend that we expect to follow suit in other countries (Chart 2). That will leave inflation momentum, and eventual interest rate hikes, to be driven more by domestic services inflation that will prove to be less correlated across countries over the next 6-12 months (Chart 3). Chart 2Inflation & Rate Hike Expectations Have Become Correlated. . . Inflation & Rate Hike Expectations Have Become Correlated. . . Inflation & Rate Hike Expectations Have Become Correlated. . . ​​​​​​ Chart 3. . .Making Our Global Golden Rule All About Inflation . . .Making Our Global Golden Rule All About Inflation . . .Making Our Global Golden Rule All About Inflation ​​​​​​ With that in mind, we revisit our framework for linking government bond returns to monetary policy outcomes versus expectations, the Global Golden Rule of Bond Investing. A Brief Overview Of The Global Golden Rule 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 and Treasury returns. Related Report  Global Fixed Income StrategyRevisiting Our Global Golden Rule Of Bond Investing We discovered that relationship also held in other developed market countries. This gave us a framework to help project expected global 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 (a.k.a. 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 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 labeled “+25bps” 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. Showing these scenarios allows us to pick the one that most closely correlates to our own expectation for central bank actions, translating that into government bond return expectations. Global Golden Rule: US Chart 4Risk/Reward Favors Less UST-Bearish Fed'Surprises' Risk/Reward Favors Less UST-Bearish Fed'Surprises' Risk/Reward Favors Less UST-Bearish Fed'Surprises' US Treasuries have delivered a painful loss of -7.8% versus cash over 12 months. Bearish outcomes of such magnitude were last seen during 1994 and 1999 when the Fed was aggressively lifting the funds rate. The Fed delivered a smaller hawkish surprise over the past year than those 1990s episodes, with a trailing 12-month policy rate surprise of -72bps. Thus, the Golden Rule underestimated losses realized by US Treasuries, as US bond yields moved to price in far more Fed tightening than what was expected one year ago. The US OIS curve now discounts +229bps of rate hikes over the next 12 months, taking the fed funds rate to 3.3% (Chart 4). That is a more aggressive profile than was laid out in the March 2022 Fed “dots”, where the median FOMC member projection called for the funds rate to climb to 2.8% in 2023. That means there is less scope for Fed rate hikes to surprise versus market expectations that are already very hawkish, at a time when US growth and inflation momentum is rolling over. Our base case calls for the Fed to deliver +200bps of rate increases over the next year, +50bps at the next two policy meetings followed by +25bps at the subsequent four meetings. That outcome produces a Golden Rule forecast of the overall US Treasury index yield falling -13bps, generating a total return of +3.73% (Tables 1 & 2). Table 1US: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 2US: Expected Changes In Treasury Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Canada Chart 5Canadian Bonds Selloff After A Hawkish BoC Canadian Bonds Selloff After A Hawkish BoC Canadian Bonds Selloff After A Hawkish BoC Canadian government bonds have sold off hard over the past 12 months, delivering an excess return over cash of -7.5% (Chart 5). That loss reflects the Bank of Canada’s (BoC) hawkish turn, but is a less severe outcome compared to other developed economy government bond markets that saw a major repricing of rate hike expectations like the US and Australia. Losses in the Canadian government bond market were consistent with the +34bps of hawkish surprises delivered by the BoC, which tightened by +75bps on a 12-month basis versus the +41bps expected by markets in May 2021. Rate expectations are highly aggressive on a forward basis. The Canadian OIS curve now discounts 210bps of interest rate increases over the next 12 months. However, high household debt in Canada, fueled by a relentlessly expanding housing bubble, will limit the ability of the BoC to match the Fed’s rate hikes over the next 6-12 months. Higher debt levels also imply a lower nominal neutral rate of interest, as the BoC has less room to hike before debt servicing costs become overly burdensome for overleveraged Canadian consumers. Our base case is that the BoC will deliver +150bps of tightening over the next 12 months. This produces a Golden Rule forecast of a decline in the overall Canadian government bond index yield of -17bps, delivering a projected total return of 4.52% (Tables 3 & 4). Table 3Canada: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 4Canada: Expected Changes In Government Bond Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Australia Chart 6Aggressive Rate Hike Expectations On A Forward Basis For Australia Aggressive Rate Hike Expectations On A Forward Basis For Australia Aggressive Rate Hike Expectations On A Forward Basis For Australia Australian government bonds have delivered a negative excess return over cash of -9.6% over the past year (Chart 6). This is the biggest sell-off among all the countries covered in our Global Golden Rule framework. The magnitude of those realized losses far exceeded what would have been predicted by the Golden Rule a year ago, with the Reserve Bank of Australia (RBA) delivering only a modest hawkish surprise. An unexpectedly high Australian headline inflation print of 5.1% in Q1 of this year led the RBA to deliver a surprise +25bps rate hike in April. This created a mild hawkish policy rate surprise of -17bps over the past 12 months, as only +8bps of tightening had been discounted in the Australian OIS curve in May 2021. The Australian OIS curve is now discounting 292bps of rate hikes over the next year, taking the cash rate to just over 3% - a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. The RBA appears confident in the Australian economy, forecasting the unemployment rate to reach a 50-year low around 3.5% in 2023. However, we believe the RBA will be more measured in its pace of rate increases over the next year than markets expect, as global traded goods inflation cools and Australian wages are still not overheating. According to the Golden Rule projections, our base case of +150bps of tightening will produce a decline in Australian government bond index yield of -92bps, delivering a projected total return of 9.29% (Tables 5 & 6). Table 5Australia: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 6Australia: Expected Changes In Government Bond Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: UK Chart 7The BoE Will Hike Less Than Markets Expect The BoE Will Hike Less Than Markets Expect The BoE Will Hike Less Than Markets Expect UK government bonds have gotten hit hard over the past year, delivering a negative excess return over cash of -7.9% - one of the worst performances seen over the past quarter century (Chart 7). The size of that loss was in line with the Global Golden Rule forecasts, given the magnitude of the rate shock seen in the UK. The Bank of England (BoE) hiked rates by 90bps over the past 12 months, which was a hawkish surprise of -79bps compared to what was discounted one year earlier. The UK OIS curve is now priced for another +139bps of rate hikes over the next year. This would take the BoE’s Bank Rate to 2.4%, a level that would push the UK unemployment rate up by two percentage points and lower UK inflation to below 2% within the next 2-3 years, according to the BoE’s own forecasting models. As we discussed in our report last week, where we upgraded our stance on UK Gilts to overweight, the neutral level of UK policy rates is between 1.5-2%, at best, with UK potential growth barely above 1%. Thus, markets are already pricing in a very restrictive monetary policy stance from the BoE that is unlikely to be fully delivered before UK growth and inflation decline sharply. Our base case calls for the BoE to deliver only another +75bps of hikes over the next year, which will produce a fall in the UK government bond index yield of -21bps and a total return of 4.12% (Tables 7 & 8). Table 7UK: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 8UK: Expected Changes In Gilt Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Germany Chart 8German Bunds Stand To Gain From An ECB Dovish Surprise German Bunds Stand To Gain From An ECB Dovish Surprise German Bunds Stand To Gain From An ECB Dovish Surprise German government bonds suffered major losses over the past year, underperforming cash by -8.5% over the past year. We saw no policy surprise from the European Central Bank (ECB) over that time relative to market expectations (Chart 8). The dramatic sell-off instead reflected surging expectations of future tightening as the euro area faces an energy-driven inflation spike. The trailing 12-month policy rate surprise for Germany (and the overall euro area) remains stuck near zero. However, markets now expect a very aggressive move by the ECB, discounting a full +156bps of tightening over the next 12 months. This would push the ECB’s main refinancing rate to levels last seen in the disastrous tightening cycle during the 2011 European debt crisis. As argued by our colleagues at BCA Research European Investment Strategy, the euro area is heading into a growth slowdown and energy inflation looks set to peak. Even if the hawks are able to sway the ECB Governing Council to begin hiking rates this summer, the slowing trajectory of growth and inflation make it highly unlikely that the ECB will deliver the full amount of tightening currently discounted. Our base case is that the ECB will deliver only +50bps of tightening over the next 12 months, enough to push the deposit rate out of negative territory to 0%. As shown in Tables 9 & 10, this is consistent with the Germany government bond index yield falling -55bps, delivering an index return of 5.07% over a 12-month horizon. Table 9Germany: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 10Germany: Expected Changes In Bund Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Global Golden Rule: Japan Chart 9The Upside On A BoJ Dovish Surprise Is Limited The Upside On A BoJ Dovish Surprise Is Limited The Upside On A BoJ Dovish Surprise Is Limited Japanese government bonds (JGBs) have delivered an excess return versus cash of -1.8% over the past twelve months (Chart 9). The policy rate surprise was flat as the Bank of Japan (BoJ) kept the policy rate unchanged at -0.1%. Admittedly, the Golden Rule framework is poorly suited to project Japanese bond returns. The BoJ has been unable to lift policy rates for many years, while instituting yield curve control on 10-year JGBs since 2016 to anchor 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. However, rates traders are making some attempt to challenge the BoJ’s ultra-dovish posture. The Japan OIS curve now discounts +9bps of tightening, approximately enough to push the policy rate to zero, over the next 12 months. With the yen weakening rapidly and the cost of imported energy elevated, consumer price inflation in Tokyo (excluding fresh food) hit the BoJ’s 2% target in April. However, as evidenced in the minutes of the March BoJ meeting, policymakers see a sustainable inflation overshoot as unlikely. Our base case is the “Flat” scenarios shown in Tables 11 & 12, with the BoJ keeping policy rates unchanged for the next twelve months and delivering a slight dovish surprise. That generates a Golden Rule forecast of a -6bps fall in the Japanese government bond index yield, with a total return projection of 0.87%. Table 11Japan: Government Bond Index Total Return Forecasts Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Table 12Japan: Expected Changes In JGB Yields Over The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Investment Implications Of The Global Golden Rule Projections For all the countries discussed above, our base case calls for the respective central banks to deliver less tightening than markets are discounting over the next year. This suggests that government bonds should be expected to deliver positive returns versus cash, even as we expect multiple rate increases from all central banks except the BoJ. While this could argue for an above-benchmark duration stance at the overall global level, we prefer to translate the Global Golden Rule results via country allocations – as we have greater conviction on relative central bank moves in the current high inflation environment – while keeping overall global duration exposure at neutral. The return outcomes for our base case scenarios for the six countries in our Global Golden Rule framework are presented in Table 13. We show the expected returns both in local currency and hedged into US dollars, the latter allowing a comparison in common currency terms. In our base case scenarios, we expect Australian and German government bonds to deliver the strongest performance over the next year, followed by the UK, Canada, the US and Japan. Table 13Our Global Golden Rule Base Case Scenarios For The Next 12 Months Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Chart 10Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Downgrade 'Defensive' Low-Yield-Beta JGBs To Underweight Our UK upgrade to overweight last week was a change to our strategic call on Gilts. Based on the results from our Global Golden Rule update, increased exposure to UK Gilts should be “funded” in a global bond portfolio by reducing exposure to Japan, with JGBs expected to deliver the weakest returns. Cutting JGB exposure also fits with the signal from our Global Duration Indicator, which is heralding a peak in global bond yield momentum in the latter half of 2022 (Chart 10). JGBs are typically a good “defensive” overweight country allocation in an environment of rising global bond yields. Persistently low Japanese inflation prevents the BoJ from credibly signaling rate hikes when other central banks like the Fed are lifting rates in response to stronger growth or overshooting inflation as is currently the case. The relative performance of Japan versus the Bloomberg Global Treasury benchmark index (in USD-hedged terms) is highly correlated to the year-over-year momentum of the overall level of global bond yields. With our Duration Indicator signaling a peak in yield momentum, we expect JGBs, which continue to exhibit a very low “beta” to changes in global bond yields, to underperform. Thus, this week we are downgrading our strategic allocation to Japan from overweight (4 out of 5) to underweight (2 out of 5). We view this as an offsetting recommendation to our UK upgrade from last week, while leaving our other country allocations unchanged. The result is that our country recommendations now line up with the expected returns from our Global Golden Rule, as can be seen in Table 13. That includes leaving the recommended US Treasury exposure at underweight, as we expect the Fed to deliver the smallest dovish surprise out of the central banks discussed in this report. We are adding both of the view changes made over the past two weeks, upgrading the UK and downgrading Japan, to our model bond portfolio as seen on pages 20-21. Bottom Line: Our Global Golden Rule suggests that developed market government bonds are expected to deliver positive returns over the next year as softening inflation momentum leads central banks to not fully deliver discounted rate hikes. Return expectations look most attractive in Australia, Germany and the UK, especially compared to the US and Japan.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Deborah Acri Research Associate deborah.acri@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. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Updating Our Global Golden Rule Of Bond Investing As Inflation Momentum Peaks Tactical Overlay Trades

Listen to a short summary of this report.     Executive Summary The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107       Short EUR/JPY 2022-05-12 133.278 120 137       Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon.       Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar Chart 2The Fed And The Dollar The Fed And The Dollar The Fed And The Dollar Chart 3The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? How Sustainable Is The Breakout How Sustainable Is The Breakout The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106.  Euro: A Recession Is Priced Chart 8Go Short EUR/JPY Go Short EUR/JPY Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months.  Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? A Capitulation In The Yen? A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY.  British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro.  Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon.  New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand.  A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk.   The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar.  Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent.  Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon.  Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Swiss Inflation Will Fall Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR.  The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside.  Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg.  Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside SEK Has Upside SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March.  The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year.  Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com   Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Favor ASEAN And The Philippines Favor ASEAN And The Philippines Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Chart 4Opinion Shifts Against China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance ​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s ASEAN's Exports To US Surge Ahead Of China's ASEAN's Exports To US Surge Ahead Of China's Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 8China Threatens ASEAN With Import Substitution Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 12BProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 13Capital Formation Favors Philippines Capital Formation Favors Philippines Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ​​​​​​ Chart 15Favor The Philippines Favor The Philippines Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary   The surge in food prices following Russia's invasion of Ukraine will drive EM headline inflation higher, given more of individuals' incomes in these economies are spent on food. Economies in the MENA will remain at risk for higher food prices, given their reliance on wheat imports from Ukraine and Russia, which together comprise ~ 30% of global wheat exports.  Wheat is the most widely traded grain in the world; its production is second only to that of corn.  Higher shipping and input costs – especially for fertilizers – will exacerbate the upside price pressure on grains, particularly wheat. Tenuous social contracts raise the risk of social unrest in MENA reminiscent of the Arab Spring unrest of 2011, which was fueled by food scarcity, economic stagnation and popular anger at autocratic governments. A strong USD will continue to raise the local-currency cost of grains and food, which also will fuel EM inflation. The War Increased Food Prices… High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Bottom Line: Wheat prices will remain volatile with a bias to the upside for as long as the Russia-Ukraine war persists.  The uncertain evolution of this war means EM states will be more exposed to grain-price volatility and higher inflation.  This could prove to be destabilizing to MENA states in particular.  Separately, we update our recommendations below.  Feature High food prices will drive EM headline inflation, owing to the fact a higher proportion of individuals’ incomes in these economies are spent on food. These pressures are particularly acute for wheat following Russia's invasion of Ukraine. Related Report  Commodity & Energy StrategyCopper Demand Will Ignore Recession Wheat is the most widely traded grain in the world, according to the World Population Review (WPR).1 In terms of global production, it is second only to corn, totaling 760mm tons in 2020. In order, the top three wheat producers in the world are China, India, and Russia, which account for 41% of global output. The US is the fourth-largest producer. The WPR notes that if the EU were to be counted as a single country, its wheat production would be second only to China (Chart 1). Within emerging markets, the Middle East and North African (MENA) nations will be worst hit by rising wheat prices.2 This is because the bulk of their wheat imports are sourced from Russia and Ukraine, and shipped from Black Sea ports, which are literally caught in the crosshairs of the Russia-Ukraine war. Many of these states do not have sufficient grain reserves to tide themselves over this crisis, and will be forced to import food at elevated prices. A strong USD, which this past week hit a 19-year high, will add to the price of USD-denominated commodity imports, particularly wheat. Russia’s invasion of Ukraine will continue to exacerbate EM food scarcity and drive input costs – e.g., fertilizers – and shipping rates higher. This will keep food and wheat prices volatile with a strong bias to the upside (Chart 2). Chart 1Wheat Production Faces Concentration Risk High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 2The War Increased Food Prices… High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation In addition to the inflation risk from high food and energy prices, the tenuous social contracts in many states again raises the risk of social unrest in MENA, as occurred in the 2011 Arab Spring protests against food scarcity, economic stagnation and autocratic government.3 War Disruptions Will Continue Russia’s invasion of Ukraine jeopardized wheat supply from two countries which together constitute nearly 30% of total global wheat exports. The invasion will continue to keep wheat prices volatile and biased to the upside (Chart 3). The UN Food and Agriculture Organization (FAO) forecasts Ukraine’s 2021/22 wheat output will drop below its 5-year average, since at least 20% of total arable land cannot be used due to the war. While nearly 60% lower than this time last year, Ukrainian wheat exports in March were not completely shut down. However, they were re-routed around the direct routes from the Black Sea.4 In March, Ukraine managed to export 309k tons of wheat. Chart 3...Particularly Wheat ...Particularly Wheat ...Particularly Wheat Ukraine will need to rely on these convoluted routes until port services are either restored or unblocked. Exports through more circuitous routes will delay distribution and increase transport costs. This, of course, also adds to the delivered cost of wheat that is being rerouted and slows the overall distribution of grains globally. Additionally, Ukrainian exports via other countries will be disrupted by those countries’ own trade slowdowns, since global bottlenecks affects all trade. Thus far, Russia has been able to maintain wheat exports. Russia continued to supply wheat to global markets in March and April. The USDA estimates that during the 2021/22 crop year, which ends in June, Russian wheat exports will total 33mm tons, which is just 2mm tons lower than the USDA's pre-crisis estimate.5 Because of high carryover stocks and record production, Russia's exports in the 2022/23 crop year are expected to be more than 40mm tons. Sourcing Alternative Wheat Supplies With a sizable portion of global wheat supply at risk – primarily from Ukraine – other exporting countries will need to increase output to fill this gap (Chart 4). This production, however, is not guaranteed, as it depends primarily on weather and fertilizer prices. New trade routes will also need to be created. This will tax existing export infrastructures as shipping dynamics are reconfigured. Particularly important will be how far the new-found sources of supply have to travel to deliver grain, shipping availability, and, of course, the incremental costs incurred to move supplies. As of 2021, the EU – the Black Sea states’ principle competitor in the wheat-export market – and 48% of total wheat exports to Middle East and African countries (Chart 5). The EU's ability to increase exports for the remainder of the 2021/22 crop year will depend on its production, since demand for exports will be guaranteed given the crisis in the Black Sea. Chart 4Other Exporters Will Need To Ramp Up High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 5MENA Is EU’s Primary Wheat Export Market High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation The European Commission expects the EU to export a record 40mm tons of wheat for the 2022/23 market year, 6mm tons higher than its expected 2021/22 exports. Based on past trade patterns, these excesses will go to the Middle East, Northern and Sub-Saharan Africa. Strong USD Favors LatAm Exports US wheat exports will not be competitive this year or next, given the strong USD and relatively high prices (Chart 6). Additionally, this year’s winter-wheat crop will be affected by current drought conditions in the key Hard Red Winter wheat growing regions of Western Kansas, Colorado, Oklahoma and Texas. Canada faces a similar issue to its North American neighbor. Compared to other major wheat exporting states, it exports wheat at the second highest price, after the US. Furthermore, in 2021/22 Canadian wheat output is expected to be the lowest in 14 years following a warm and dry summer. The USDA expects strong Argentinian and Brazilian wheat exports in 2021/22. Compared to exports from the EU, US, Australia and Canada, wheat from these two sources is cheaper and hence will attract price sensitive bids from the Middle East and Africa. Chart 6US Wheat Remains Non-Competitive US Wheat Remains Non-Competitive US Wheat Remains Non-Competitive A strong USD will incentivize the LatAm giants’ wheat exports since their input costs are in local-currency terms and their revenues are in USD. While some countries have taken advantage of high wheat and food prices to increase exports, others have imposed restrictions or outright bans on exports, which will continue to drive prices higher. Kazakhstan, which constitutes nearly 5% of global wheat exports, now has a quota on such exports, which will affect Central Asian import markets. India was expected to constitute an uncharacteristically large share of wheat exports this year and next. However, the country is experiencing its hottest March in 122 years, which most likely will reduce its harvest this year and incentivize it to keep wheat stocks at home. The world’s second largest wheat producing and consuming nation expects a 6% drop in production this year.6 Fertilizer Costs Will Remain High … Countries’ abilities to increase production will depend on fertilizer availability and costs. The USDA cited high fertilizer prices as one of the causes for lower expected Australian wheat output in 2022/23. Prices of natural gas – the primary feedstock for fertilizers – took off like a rocket following Russia's invasion of Ukraine. High natgas prices feed directly into fertilizer costs (Chart 7). The EU's proposal to ban Russian oil imports could see Russia embargo natgas supply in retaliation, which would further spike natgas and fertilizer costs. This will have knock-on effects on all ags markets. Fertilizer export bans announced by Russia and China are another factor driving fertilizer prices higher (Chart 8). High fertilizer costs most likely will dissuade farmers from using fertilizers in volumes associated with more normal market conditions, and likely will cause them to wait on planting and treating acreage, which will lower crop quality or delay planting. Both scenarios will lead to higher crop prices (Chart 9). Chart 7High Natgas Prices Feeds Right Into Fertilizers High Natgas Prices Feeds Right Into Fertilizers High Natgas Prices Feeds Right Into Fertilizers Chart 8Russia, China Are Big Fertilizer Exporters High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 9Nitrogen Fertilizer Prices Continue To Rise Nitrogen Fertilizer Prices Continue To Rise Nitrogen Fertilizer Prices Continue To Rise …As Do Shipping Costs Redrawing trade routes – i.e., finding new supplies and new shippers to compensate for the loss of Ukrainian wheat exports – will be expensive. For example, US grain shipping costs soared to an 8-year high after countries, led by China, dramatically increased soybean imports from the US due to a drought in Brazil.7 In 2021, high shipping costs led directly to higher food prices (Chart 10).8 Shipping, like any other commodity, is a function of supply and demand for different types of vessels capable of carrying grain from one part of the world to another. On the supply-side, port closures in China and the Black Sea are increasing port congestion, and making ships available for moving grains scarce. The Ukraine war has stranded ships in the Black Sea and forced merchants to re-route their shipments. This increases sailing times, which has the effect of contributing to supply scarcity in shipping markets. Fewer available ships, coupled with high fuel prices are keeping freight rates elevated. A low orderbook of expected new-vessel additions to the global shipping fleet in 2022 and 2023, along with guidance for ships to reduce speeds to increase fuel efficiency, will exacerbate current ship supply scarcity.9 On the demand side, the major international economic organizations have reduced 2022 GDP estimates due to lower economic activity. Lower economic activity will translate into lower ship demand and hence reduce prices (Chart 11). Chart 10Shipping Prices Remain Elevated Shipping Prices Remain Elevated Shipping Prices Remain Elevated Chart 11Shipping Demand Driven By Economic Activity Shipping Demand Driven By Economic Activity Shipping Demand Driven By Economic Activity   Shipping prices will drop meaningfully once port congestion clears. This will depend on the duration of COVID-19 in China and the evolution of the Russia-Ukraine war. A recession – the probability of which will increase if the EU bans Russian oil imports and Russia retaliates with its own natgas ban – acts as a downside risk to shipping costs. Investment Implications The gap in Black Sea wheat exports produced by the Russia-Ukraine war will require a ramp-up in other countries’ supply. Higher production is contingent on weather conditions and input costs. Changing weather patterns, due to climate change, will increase food insecurity, and make it more difficult to predict how ag markets – particularly grain trading – will handle this shock and other shocks down the road. We remain neutral agricultural commodities but will follow wheat and food market developments closely.   Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodity Round-Up Energy: Bullish Going into the Northern Hemisphere's summer driving season, US retail gasoline prices are trading at record levels -- $4.328/gal ($181.78/bbl) as of 9 May 2022, according to the US Energy Information Administration (Chart 12). Regular gasoline (RBOB specification traded on the NYMEX) for delivery in the NY Harbor settled at $144.27/bbl ($3.4349/gal) on Tuesday, giving refiners a rough wholesale margin (versus Brent crude oil) of $41.81/bbl. Retail diesel fuel prices also have been extremely well bid, posting record highs as well of $5.623/gal ($236.17/bbl) on 9 May 2022 (Chart 13). On the NYMEX, the ultra-low sulfur diesel fuel contract for July delivery settled at $3.6793/gal ($154.53/bbl). Jet fuel prices also are extremely well bid, as demand increases against a backdrop of lower refinery output pushed NY Harbor prices to $7.61/gal ($319.62/bbl) on 4 April 2022. NY Harbor jet-fuel prices have been much stronger than US Gulf prices and European prices seen in the Amsterdam-Rotterdam-Antwerp (ARA) markets, which were averaging ~ $3.60/gal, according to the EIA. This is accounted for by robust demand – evident since mid-2021, when it recovered pandemic-induced losses – and lower-than-normal output of jet by refiners. Assuming the US does not go into a profound recession, refined-product markets likely will remain tight during the summer-driving season and into the rest of this year, in our estimation. As is the case with the Exploration & Production companies, refiners also have been parsimonious with their capex, which translates into lower capacity to meet demand. Base Metals: Bullish Per the latest US CFTC data, we believe hedge funds and speculators investing in copper are dismissing bullish micro fundamentals and are focusing on bearish macroeconomic factors, such as the probability of an economic slow down increases. This would explain why funds’ short positions have exceeded long positions for the first time since end-May 2020. We have written about medium-to-long-term bullish micro fundamentals at length in previous reports.10 On micro fundamentals, the Chilean constitutional assembly passed articles expanding environmental protection from mining over the weekend. These will be added to the draft constitution to be voted on in September. The article expanding state control in Chilean mining activity did not pass and will be renegotiated before being sent back to the constitutional assembly for a second vote. Uncertain governance will affect mining investment in the state, as BHP recently highlighted. Chart 12 High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation Chart 13 High Food Prices Drive EM Inflation High Food Prices Drive EM Inflation           Footnotes 1     Please see Wheat Production by Country 2022, published by worldpopulationreview.com. 2     Awika (2011) notes, "… cereal grains are the single most important source of calories to a majority of the world population. Developing countries depend more on cereal grains for their nutritional needs than the developed world. Close to 60% of calories in developing countries are derived directly from cereals, with values exceeding 80% in the poorest countries." Please see Joseph M. Awika (2011), "Major Cereal Grains Production and Use around the World," published by the American Chemical Society. The three most important grains in this regard are rice, corn and wheat. 3    Please see Egypt's Arab Spring: The bleak reality 10 years after the uprising, published by dw.com on January 25, 2021. 4    Please see First Ukrainian corn cargo leaves Romanian Black Sea port, published by Reuters on April 29, 2022. 5    All USDA estimates mentioned in this report are taken from the USDA’s Grain and Feed Annual for each country. 6    Please refer to After five record crops, heat wave threatens India’s wheat output, export plans, published by Reuters on May 2, 2022. 7     Please refer to U.S. Grain Shipping Costs Soar With War and Drought Swinging Demand, published by Bloomberg on March 18, 2022. 8    For a more detailed discussion, please refer to Risk of Persistent Food-Price Inflation, which we published on November 11, 2021. 9    For estimates of orderbook vessels in 2022/23 please see Shipping market outlook 2022 Container vs Dry bulk, published by IHS Markit on November 30, 2021; slower speeds could reduce effective shipping capacity by 3-5%, according to S&P Global (see Shipping efficiency targets could prompt slower speeds and reduced capacity: market sources). 10   For the latest on this, please see Copper Demand Will Ignore Recession, which we published on April 14, 2022.   Investment Views and Themes Recommendations   Recommendations: We are re-establishing our positions in XME, PICK and XOP, which were stopped out APRIL 22, 2022 with gains of 42.42%, 9.77% and 20.91%, respectively, at tonight's close. We also will be adding the VanEck Oil Refiners ETF (CRAK) to our recommendations, given our bullish view of the global refining sector. Strategic Recommendations   Trades Closed in 2022 Image  

Executive Summary India’s annual consumer price inflation will rise a notch from current levels but is unlikely to surpass 8% in a sustained manner. Demand-driven price pressures are absent in the Indian economy. So are wage pressures. That leaves commodity prices as the sole source of inflation. Global industrial commodity prices dictate India’s producer price inflation, but not consumer price inflation. The latter is determined by domestic factors. Higher import costs on fertilizer and edible oils will push up India’s food inflation a bit, but food inflation is mainly affected by the ‘Minimum Support Price’ that the government pays to farmers for food procurement. The central bank is making a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is quite weak. The Indian profit outlook has deteriorated meaningfully due to falling margins. Higher interest rates will add to the headwinds. This bourse is also very expensive relative to its EM peers. India: Consumer Price Inflation Is A Function Of Broad Money Supply India: Consumer Price Inflation Is A Function Of Broad Money Supply India: Consumer Price Inflation Is A Function Of Broad Money Supply Bottom Line: Absolute return investors should avoid this bourse. Asset allocators should stay underweight India in EM and Emerging Asian equity portfolios. Bond investors should stay neutral India in EM and Emerging Asian domestic bond portfolios. Feature In much of the developed world, inflation has risen to 40-year highs. Inflation has surged in many developing countries as well. India has been one major exception in the latter group − where both headline and core consumer inflation have remained rangebound so far (Chart 1). The question is, if and for how long will India be able to buck the tide of higher global inflation? On a related note, what would be the likely effects of higher inflation on Indian markets? We believe headline and core CPI in India will rise from the current levels of around 6.5%; but will not go past 8% on a sustainable basis. This is much below the double digit levels the country often witnessed in the 1990s and 2000s. The main reason behind our optimism is that demand-driven price pressures are absent in the current cycle. The sole source of inflation is higher global commodity prices, which could be peaking on a rate of change basis. The commodity-led nature of inflation in India also makes monetary policy a less effective tool to control it in this cycle. In fact, considerable monetary tightening will be a policy error as it could nip the already weak domestic demand in the bud. We turned bearish on Indian stocks in March this year, and believe they have more downside in absolute terms. Their recent relative outperformance will also fizzle out sooner rather than later, as this was partially due to investors forsaking the Chinese market. This caused a sharp fall in the latter boosting other bourses’ relative performances (Chart 2). Chart 1India Has So far Been An Exception To The Global Trend Of Surging Inflation India Has So far Been An Exception To The Global Trend Of Surging Inflation India Has So far Been An Exception To The Global Trend Of Surging Inflation Chart 2Indian Stocks Will Weaken More And Underperform EM Indian Stocks Will Weaken More And Underperform EM Indian Stocks Will Weaken More And Underperform EM   Investors would therefore do well to stay underweight Indian stocks in EM and Emerging Asian equity portfolios for now. Local currency bond investors should stay neutral India in the respective EM and Emerging Asian bond portfolios. Why Has Inflation Stayed Downbeat? Just like in other economies, labor productivity trends set the tone of India’s structural inflation backdrop. Up until the early 2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. Thereafter, a surge in capital spending on infrastructure and other productive capacity propelled India’s average annual productivity growth rate to twice as high. This has helped improve India’s structural inflation backdrop considerably. That said, over a cyclical horizon, it is the ebbs and flows of broad money supply (M3) that determines India’s consumer inflation trajectory (Chart 3). Chart 3India: Consumer Price Inflation Is A Function Of Broad Money Supply India: Consumer Price Inflation Is A Function Of Broad Money Supply India: Consumer Price Inflation Is A Function Of Broad Money Supply Chart 4Money Supply Will Stay Tame As Its Sources Are Rather Muted Money Supply Will Stay Tame As Its Sources Are Rather Muted Money Supply Will Stay Tame As Its Sources Are Rather Muted Broad money supply in India has decelerated over the past year and a half. This is in sharp contrast to most developed economies and many emerging economies in Latin America and EMEA; and it is the main reason why inflation prints have diverged between those countries and India. In the foreseeable future, there is little indication that India’s broad money supply will accelerate by any meaningful measure. This is because the major sources of money creation – bank credit origination and the central bank and commercial banks’ purchases of non-bank securities − have all remained rather muted in the recent past. Bank credit has grown only at a 7% nominal annualized rate over the past three years. In real terms (deflated by headline CPI), they have barely risen. Commercial banks’ purchases of government bonds are growing at only 5%. The central bank’s monetization of government debt, the other source of money creation, has also decelerated since early 2020 (Chart 4). The decelerating broad money supply means the odds of a demand-driven surge in consumer price inflation is also quite low. What About Commodity-Led Inflation? Elevated commodity prices have pushed up India’s consumer price inflation by a notch. Yet, given that much of the rally in global industrial commodities is probably already behind us, it’s effect on future inflation in India will likely be limited: Global industrial commodity prices drive India’s producer price inflation1 (PPI). But the correlation with India’s consumer price inflation is only tenuous (Chart 5). Moreover, given that India’s PPI tracks global commodity prices with a few months lag, this is also set to decelerate in the coming months.  Consistently, the pass-through effect from high global crude prices to local gasoline and diesel prices in India has also rolled over on a rate of change basis (Chart 6, top panel). Chart 5Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Chart 6Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest   Notably, Indian authorities did not reduce local gasoline and diesel prices back in 2020-21 when global crude prices had slumped. Hence, the incremental rise in local fuel prices in the past several months has not been as steep as they might have been (Chart 6, bottom panel). As a result, energy-related inflation prints in India are not as high as crude oil prices would suggest. In fact, CPI for Fuel & Light and Transport & Communication2 have both decelerated from 12%+ YoY rate to 8% and are slowing further. That means the pass-through from higher fuel prices to the rest of the economy going forward will also be receding. Fertilizer (mostly potash) and edible oil3 are the two other major commodities that India imports. The import bill of these two items has almost doubled in dollar as well as in rupee terms in the past year due to surging prices globally. Together, they now account for 5% of India’s total imports. Higher import costs of these items will lead to slightly higher food prices in future. That said, India’s food inflation moves more with the “Minimum Support Price” (MSP). This is the price that the government pays to farmers for procuring various food grains every year (Chart 7, top panel). Since the government is by far the single largest purchaser, the price it pays sets the floor in the market. In recent years, authorities did not hike procurement prices by much. Unless authorities announce a much higher MSP for the current year, both food and headline CPI will likely stay under control. Finally, India is largely self-reliant when it comes to food. The buffer stock of the country’s food grains, currently at 74 million tons, far exceeds the estimated requirements (Chart 8). Short of any logistics debacle therefore, it’s hard to imagine that food prices could soar sustainably. Chart 7The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages Chart 8India's Buffer Stock Of Food Grains Is Quite Robust India's Buffer Stock Of Food Grains Is Quite Robust India's Buffer Stock Of Food Grains Is Quite Robust   All that said, food inflation is the main risk on India’s inflation horizon. The reason for that is rising food prices often unmoor household inflation expectations, and eventually lead to higher realized inflation. Chart 9 shows that higher food prices in India do leak into non-food prices, albeit to a limited extent. As such, marginally higher food prices owing to higher import costs of fertilizer and edible oils will see India’s core inflation also rise a bit.   Chart 9Higher Food Inflation Leaks Into Core Inflation, But Only So Much Higher Food Inflation Leaks Into Core Inflation, But Only So Much Higher Food Inflation Leaks Into Core Inflation, But Only So Much How High Can Core CPI Rise? As discussed, India’s core inflation will likely remain mostly under control. A crucial reason for that is wage pressures are absent in India. This is in stark contrast to the US, where high wage pressures are threatening to morph into a wage-inflation spiral. In rural India, both farm and non-farm nominal wages have been growing at an average sub-5% rate since 2016, which is below CPI inflation. One reason rural wages have stayed low is that authorities have not raised the MSP much in recent years. A lower MSP not only reins in food prices, but it also keeps a tab on wages (Chart 7, bottom panel). As such, unless the government decides to raise the MSP meaningfully this year, it will be difficult for rural wages to rise materially. On the urban side, the RBI survey on expectations for industrial salary and remunerations also depicts a similarly subdued outlook (Chart 10). Going forward, as tens of millions of young people continue to join the workforce every year, the broader wage picture in India is unlikely to change much. Subdued wage pressures will help keep a tab on the general inflationary pressures in the economy. On its own, India’s core CPI (i.e., CPI ex-food and ex-fuel) is largely a function of domestic money and credit trends. Global crude oil prices also matter to some extent. However, as discussed above, few of these variables are accelerating sharply. That means odds are low that core CPI will rise much more from the current levels. Indeed, our in-house model for core CPI, based on the variables just mentioned, points to a rather benign outlook (Chart 11). Chart 10Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Chart 11India's Inflation Outlook Is Sanguine India's Inflation Outlook Is Sanguine India's Inflation Outlook Is Sanguine   Does Inflation Hurt Indian Stocks? The primary drivers of Indian stocks are economic growth and corporate profits. Stock prices do not usually get hurt as long as CPI stays in low and mid-single digits. However, once CPI breaches the 8% mark sustainably, stocks typically sell off (Chart 12). Chart 12Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Chart 13Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth The reason is that when inflation is sustainably high, meaningful monetary tightening ensues. Higher interest rates make it costlier to borrow for either consumption or investment purposes, and therefore depresses demand in the economy. That leads to a squeeze in profit margins, which in turn weighs on equity multiples and thus equity prices.  Interestingly, unlike CPI, which has no stable correlation with Indian stock prices, PPI has a robust positive correlation with stocks. The link is via corporate earnings. Indian PPI tracks the ebbs and flows in global commodity prices, and therefore global growth. Strong global growth boosts all corporate earnings, including that of India. Accelerating PPI is therefore a harbinger of higher Indian earnings and stock prices. Going forward, however, a decelerating PPI is pointing to lower stock prices in India (Chart 13). Is RBI Making A Policy Mistake? India’s central bank seems to be committing a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is already very weak. This is negative for the economy and share prices. Chart 14Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend The Reserve Bank of India surprised the market last week by raising policy rates by 40 basis points to 4.4%. They also raised commercial banks’ cash reserve ratio by 50 basis points to 4.5% in order to tighten banking sector liquidity. Monetary tightening, as a policy tool, works by stifling domestic demand. It makes borrowing for the purpose of investments and consumption more costly. It is, however, rather ineffective in resolving inflation caused by higher food and fuel prices – as is the case in India presently. Notably, high commodity inflation itself forces consumers to spend a lower amount on other core items – leading to weaker demand for the latter. Further monetary tightening would exacerbate that weakness. As explained before, Indian consumer prices are driven mostly by domestic factors, such as money supply and productivity (Chart 3, above), rather than global commodity prices. This distinction is important given that the central bank’s mandate is to manage CPI, not PPI. As such, monetary policy should ideally be based on mostly domestic dynamics. India’s domestic demand is extremely soft compared to the US where inflation has skyrocketed. Given the massive negative output gap that opened up in the Indian economy during the pandemic-related lockdowns, it will take a while before this economy sees genuine, sustained overheating. In view of this softness, any meaningful hike in interest rates (say another 100 basis points) could have a material negative impact on the recovery, and by extension, on stock prices:  Household consumption is quite weak − as is evident in local car and 2-wheeler sales (Chart 14, top panel). One reason for that is the subdued wage growth mentioned above. Pandemic-era fiscal stimulus, at less than 2% of GDP, has not been nearly enough to compensate for lost household income during the lockdowns. Consistent with lackluster household demand, manufacturing and other industrial productions are also languishing at far below the pre-pandemic trend (Chart 14, bottom panel). Robust capex is what spearheaded India’s post-pandemic recovery. But, now with decelerating corporate profits, capital investments have begun to slow. Higher costs of borrowing will further discourage capex plans. If so, lower investments will do more than shave off GDP growth in the coming quarters. If continued, this could be a major risk for India’s sustainable growth story, and its ill-effects may linger. Chart 15Higher Interest Rates Are A Headwind For Stock Prices Higher Interest Rates Are A Headwind For Stock Prices Higher Interest Rates Are A Headwind For Stock Prices All in all, given the nature of inflation in India in the current cycle, it will be a mistake to raise policy rates by any meaningful measure. Both consumption and investments will be hurt. Stock prices, which clearly benefit from lower interest rates, will be facing higher rates, and will therefore sell off (Chart 15). As such, it will be difficult for the RBI to continue to tighten monetary policy without causing a significant bear market in Indian stocks.   Investment Conclusions Equities: The Indian profit outlook has deteriorated meaningfully as a result of falling margins and an impending growth slowdown. This bourse is also very expensive relative to its EM peers. Higher interest rates will add to the headwinds. Absolute return investors should avoid this market. Asset allocators should stay underweight in EM and Emerging Asian equity portfolios. Currency And Bonds: The Indian rupee could depreciate marginally along with a likely sell-off in Indian stocks. Given that higher interest rates will likely be detrimental to a growth recovery, it will discourage capital inflows, and will therefore be negative for the rupee. As the rupee could be weaker, and bond yields could rise marginally with tighter banking sector liquidity, investors should stay neutral on India in EM and Emerging Asian bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1     Also called ‘wholesale prices.’ 2     CPI for Fuel & Light has a 6.8% weight in the CPI basket. Transportation & Communication has 8.6% weight. 3    Edible oil has a weight of 3.6% in India’s CPI basket.​​​​​​​

Executive Summary The Fed, Bank of England (BoE) and Reserve Bank of Australia all hiked rates last week. The BoE, however, signaled a note of caution on future UK growth, given soaring energy prices and plunging consumer and business confidence.  Interest rate markets are pricing in a peak in UK policy rates over the next year near 2.5%, above realistic estimates of neutral that are more in the 1.5-2% range. UK productivity and potential growth remain too weak to support a higher neutral rate than that. With the BoE forecasting near recessionary conditions over the next couple of years if those market-implied rate hikes come to fruition, the time is right to increase exposure to UK government bonds in global fixed income portfolios. UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Not All Central Bankers Can Credibly Restore Credibility Chart 1Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Developed Market Bond Yields Back To 2018 Highs Three more central bank meetings, three more rate hikes. Last week brought a 50bp hike from the Fed, a 25bp hike – the first of this tightening cycle – by the Reserve Bank of Australia (RBA) and a 25bp rate increase from the Bank of England (BoE). The Fed and RBA moves did little to stabilize the government bond bear markets in the US and Australia, but the BoE was able to provide a temporary reprieve for the Gilt selloff by playing up potential UK recession (stagflation?) risks. Bond yields worldwide remains laser focused on high global inflation and the associated monetary policy response that will be needed to stabilize inflation expectations (Chart 1). That includes both interest rate hikes and reducing the size of bloated central bank balance sheets. The threat of such “double tightening” is weighing on global growth expectations and risk asset valuations. The MSCI World equity index is down -6.4% (in USD terms) so far in the Q2/2022 and down -14.5% since the mid-November/2021 peak. Although in a more mitigated way, credit markets are also being impacted, with the Bloomberg Global High-Yield index down -2.6% so far in Q2 on an excess return basis versus government bonds. Rate hike expectations have started to catch up to elevated inflation expectations, at least according to inflation linked bonds. The yield on 10-year US TIPS now sits at +0.29%, a huge swing from the -1% level seen just one month ago (Chart 2). The 10-year real yield is even higher in Canada (+0.81%) where the Bank of Canada just delivered its own 50bp rate hike in April. On the other hand, 10-year real yields remain deeply below 0% in Europe and the UK, where central bankers have been providing less explicit guidance on future rate hikes and asset purchase reductions compared to the Fed or Bank of Canada. Interest rate markets remain reluctant to price in significantly positive real policy interest rates at the peak of the current tightening cycle. Our proxy for the real terminal rate expectation, the 5-year/5-year overnight index swap rate (OIS) minus the 5-year/5-year CPI swap rate, is only +0.18% in the US. It is still deeply negative in Europe (-1.53%) and the UK (-0.97%). Our estimates of the term premium component of 10-year government bond yields in those three markets is rising alongside interest rate expectations yet remains deeply negative in Europe and the UK (Chart 3). Chart 2Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock Real Rate Divergences In The Face Of A Global Inflation Shock ​​​​​​ Chart 3Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates Markets Still Pricing In Structurally Low Rates ​​​​​​ Of those three major bond markets, we see the UK term premium as being the least likely to see additional upward repricing, with the BoE less likely than the Fed or ECB to push for an aggressively smaller balance sheet given domestic economic risks. UK Rate Expectations Are Too Hawkish Chart 4Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves Our BoE Monitor Justifies Recent Tightening Moves The Bank of England raised rates by 25bps last week, pushing Bank Rate to a 13-year high of 1.0%. The decision was a 6-3 majority, with three Monetary Policy Committee (MPC) members calling for a 50bp hike – matching recent moves by other G-10 central banks like the Fed and Bank of Canada – given tight UK capacity constraints (i.e. low unemployment) and high realized inflation. The MPC noted that additional rate increases would likely be necessary to tame very high UK inflation, a message confirmed by the elevated level of our UK Central Bank Monitor (Chart 4). However, the new economic forecasts presented by the BoE painted a gloomy picture on UK growth, raising the risks of a recession even as UK inflation is expected to continue climbing to a 10% peak in late 2022 on the back of high energy prices.1 Strictly looking at current inflation, the case for the BoE to continue hiking rates is obvious. Yet the BoE may now be placing more weight on the downside risks to growth from the energy shock, at a time when fiscal tightening is no longer providing stimulus. In the press conference following last week’s MPC meeting, BoE Governor Andrew Bailey noted the difficult situation policymakers are facing given the huge surge in energy prices that is fueling inflation while also weighing on household and business real incomes. So what is “neutral” anyway? Related Report  Global Fixed Income StrategyThe UK Leads The Way The BoE is one of the least transparent major central banks when it comes to providing guidance on what it thinks the neutral policy rate is. Market participants are left to arrive at their own conclusions and those can vary substantially, as is currently the case. The UK OIS curve is discounting a peak in rates of 2.72% in 2023 and discounting rate cuts after that starting in 2024. Yet the respondents to the BoE’s new Market Participants Survey are calling for a much lower trajectory with rates peaking at 1.75% before falling to 1.5% in 2024 (Chart 5). Those rate levels are in the lower half of the range of longer-run neutral rate estimates from the same Market Participants Survey, between 1.5% and 2.0% (the shaded box in the chart). Chart 5UK Rate Expectations Are Too High UK Rate Expectations Are Too High UK Rate Expectations Are Too High Chart 6Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Recessionary BoE Forecasts, Except For GDP Combining the messages from the OIS curve and the Survey, markets are pricing in a path for the BoE Bank Rate that will become restrictive by mid-2023, with another 172bps of rate hikes. The BoE uses market pricing for future interest rates in its economic forecasts. The Bank’s models suggest that a move to raise rates to 2.5% in response to high UK inflation, as markets are discounting, would result in a severe UK downturn that would both push up unemployment from the current 3.7% to 5.4% by Q2/2025 (Chart 6). Headline inflation would plunge to 1.3% over the same period as the UK output gap widens to -2.25% of GDP from the current “excess demand” level of +0.5%. Oddly enough, the BoE is only forecasting a flat profile for real GDP growth over that entire three-year forecasting period, although there will clearly be some negative GDP prints during that period to generate such a massively disinflationary outcome. A mixed picture on UK growth Currently, the UK economy is flashing some warning signs on growth momentum. The UK manufacturing PMI was 55.8 in April, still well above the 50 level indicating growth but 9.8 pts below the cyclical peak in 2021 (Chart 7). The services PMI is in better shape at 58.9, but it did dip lower in the latest reading. The GfK consumer confidence index has fallen sharply in response to contacting real household income growth, reaching the second-lowest reading in the history of the series dating back to 1974 in April. This is a warning sign for consumer spending – retail sales fell in April for the first time in fifteen months (middle panel). Business confidence is also impacted by the high costs of both energy and labor that is squeezing profit margins. UK real investment spending is nearly contracting on a year-over-year basis, despite the robust readings on investment intentions from the BoEs’ Agents Survey of UK businesses (bottom panel).UK firms are facing higher wage costs at a time of very tight labor market and robust labor demand. The BoE estimates that UK private sector wage growth, after adjusting for compositional effects related to the pandemic, will accelerate to 5.1% by the end of Q2/2022 (Chart 8). Chart 7UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds UK Growth Facing Inflationary Headwinds ​​​​​​ Chart 8UK Labor Market Remains Healthy UK Labor Market Remains Healthy UK Labor Market Remains Healthy ​​​​​​ Chart 9Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? Will House Prices Signal The Peak In UK Inflation? A robust labor market and quickening wage growth is forcing the BoE to maintain a relatively hawkish bias at a time of high energy inflation, even with the growth outlook darkening in the central bank’s own forecasts. Booming house prices are also making the central bank’s job more challenging. The annual growth rate of the Nationwide UK house price index reached 12.4%, a 17-year high, in March. However, rising mortgage rates and declining household real incomes will likely begin to eat into housing demand and, eventually, help slow the rapid pace of house price growth (Chart 9, bottom panel). Summing it all up, the overall UK inflation picture, including wages and housing costs in addition to energy prices and durable goods prices, will force the BoE to deliver a few more rate hikes before year-end before reaching a peak level that is lower than current market pricing. The neutral UK interest rate is likely very low Chart 10Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate Structurally Weak UK Growth = A Low Neutral Rate The UK economy has suffered from structurally low potential economic growth dating back to the Brexit referendum in 2016. UK businesses stopped investing in the face of the uncertainty over the UK’s relationship with Europe. There has basically been no growth in UK fixed investment over the past five years. In response, UK productivity has only grown an annualized 0.9% over that same period (Chart 10) and the OECD’s estimate of UK potential GDP growth has been cut from 2% to 1.1%. With such low potential growth, the neutral BoE policy interest rate is likely even lower than the 1.5-2% range of estimates from the BoE’s Market Participant Survey. Tighter fiscal policy also lowers the neutral UK interest rate, with the UK Office of Budget Responsibility forecasting a narrowing of the UK budget deficit of -13.6 percentage points between the 2021 peak and 2027 (bottom panel). A flat UK Gilt curve is also a sign that the neutral interest rate is quite low. The 2-year/10-year Gilt curve now sits at a mere -49bps with Bank Rate only at 1% (Chart 11). While this is modestly steeper from the near-inversion of the curve seen at the start of 2022, a very flat curve at a nominal policy rate of only 1% suggests that the neutral rate is not far from the current level. Sluggish UK equity market performance and widening UK corporate credit spreads also argue that Bank Rate may already be turning restrictive, although a lower trade-weighted pound is helping to mitigate the overall tightening of UK financial conditions. Chart 11UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) UK Financial Conditions Are Not Restrictive (Yet) ​​​​​​ Chart 12Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does Pressure On The BoE Will Not Peak Until Inflation Does ​​​​​​ In the end, the pressure on the BoE to tighten will not ease until UK inflation peaks. The BoE is suffering a severe credibility crisis, with its own public opinion survey showing the deepest level of public dissatisfaction with the bank since the Global Financial Crisis (Chart 12). Inflation expectations are at similar levels that prevailed during that period, although the unique nature of the current inflation upturn, fueled by global supply-chain squeezes and war-related boosts to commodity prices, will likely prevent a repeat of the relatively fast reversal of inflation expectations seen after the Global Financial Crisis. Investment Implications – Get Ready For Gilt Outperformance Chart 13Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight Upgrade UK Gilts To Overweight With the BoE already pushing Bank Rate towards a plausible neutral range, we do not expect many more rate hikes in the UK. Our base case is that the BoE hikes 2-3 more times by year-end, pushing Bank Rate to 1.5-1.75%, before pausing. This would represent a lower peak in policy rates than currently priced in the UK OIS curve. That is a relatively dovish outcome that typically leads to positive performance for a government bond market according to our “Global Golden Rule” framework, which we will revisit in next week’s Strategy Report. For now, however, we see a strong case to turn more positive on UK Gilts, with the BoE likely to deliver fewer rate hikes than discounted (Chart 13). The BoE is also far less likely to begin reducing its balance sheet by selling its Gilt holdings back to the market. BoE Governor Bailey strongly hinted last week that such aggressive quantitative tightening (QT) was not a given, even after the Bank research staff presents its proposals to the MPC in August. A delay in QT would also be a factor boosting UK Gilt performance versus other developed economy bond markets where more aggressive reductions in central bank balance sheets are more likely, like the US and potentially even the euro area. This week, we are upgrading our recommended strategic UK weighting from underweight to overweight. In next week’s report, we will consider the proper allocation for the UK within our model bond portfolio, after reviewing potential bond return forecasts stemming from our Global Golden Rule. Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1      The mechanical way that the UK government’s energy price regulator, Ofgem, sets price caps on retail gas and electricity costs - based on changes in wholesale energy costs implied by futures curves – means that UK household energy prices will rise by 40% in October, according to BoE estimates. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It’s Time To Flip The Script - Upgrade UK Gilts It’s Time To Flip The Script - Upgrade UK Gilts Tactical Overlay Trades