Inflation/Deflation

Highlights On US inflation and the Fed: If the Fed adheres to its mandate, it has no choice but to hike rates until core inflation drops toward 2% (from its current level above 4%). Yet, share prices will sell off before inflation converges toward the Fed’s target. On US TIPS yields: Rising TIPS yields will depress share prices in the richly valued equity markets like the US, support the greenback, and curtail portfolio flows into EM for a period of time. On China: Despite stimulus, China’s business cycle will continue disappointing over the near-term. Besides, a bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. On financial market divergences: Major selloffs evolve in phases resembling domino effect-like patterns. In contrast, corrections are abrupt, and the majority of markets drop concurrently. Hence, the nature of current market dynamics is more consistent with a major selloff than a short-term correction. On regional allocation within a global equity portfolio: Overweight the euro area and Japan, underweight the US and EM. Feature Ms. Mea is a long-time BCA client and an avid follower of the Emerging Markets Strategy (EMS) service. Since 2017, I have been meeting with her twice a year to exchange thoughts on the global macro environment, to discuss the nuances of our views and to elaborate on investment strategy. We always publish our conversations for the benefit of all EMS clients. This virtual meeting took place earlier this week. Chart 1A Technical Breakout Is In US Bond Yields Ms. Mea: It has been two years since we last met in person. I did not imagine that world travel would stay so depressed for so long when the pandemic began two years ago. I have also been surprised by the recent behavior of financial markets. There have been divergences that I cannot reconcile, such as the woes in China’s real estate sector and resilient commodity prices, the diverging performance of the S&P 500, US small caps and a significant portion of NASDAQ-listed stocks. I will ask you about these later. But let’s start with your main macro themes. Since early last year, you have been advocating two macro themes: (1) China’s slowdown; and (2) rising and non-transitory US inflation. They were controversial a year ago but have now become widely accepted in the investment community. Financial markets have moved a great deal to reflect these macro themes. Don’t you think financial markets have already fully priced in these macro trends? Answer: You are right that these narratives have become well known and financial markets have been moving to price in these developments. However, our bias is that these themes are not yet fully priced in and these macro forces will continue to impact financial markets over the near term. Let’s first discuss US inflation and interest rate moves. Chart 1 illustrates that US government bond yields have broken above major resistance levels. Such a breakout technically entails higher yields. Odds are that US long-term bond yields will move up by another 50 basis points in the months ahead before they pause or reverse. The fundamental justification for higher US bond yields is as follows: The inflation genie is out of the bottle in the US. If the Fed adheres to its inflation mandate, it has no choice but to hike rates until core inflation drops toward 2%. In December, trimmed-mean CPI and median CPI printed 4.8% and 3.8% respectively, well above the Fed’s preferred range of 2-2.25% for core inflation (Chart 2). Critically, these inflation measures are not impacted by volatile components. These measures strip out outliers like used and new car prices, auto parts, as well as energy and food. The core CPI and PCE inflation measures will drop this year but super core inflation will remain north of 3%, well above the Fed’s preferred range. Importantly, a wage inflation spiral is already underway in the US. Employees have experienced substantial negative wage growth in real terms in the past 12 months. Labor shortages are prevalent, and the employee quit rate is very high. Employees are demanding very high wage growth and employers will have little choice but to meet these demands (Chart 3). Chart 2US Super Core Inflation Suggests Broad-Based Inflationary Pressures Chart 3US Wages Will Be Accelerating Chart 4Rising TIPS Yields = Equity Multiples Comparison As a result, the only way to bring down core inflation toward its preferred target range is for the Fed to slow the economy down and curb employment and wage gains. Yet before core inflation converges to the Fed’s target, risk assets will sell off first. Practically, the Fed will talk hawkish and hike until something breaks. The breaking point will be a major selloff in US share prices. US equities have been priced to perfection on the assumption that US interest rates will remain low for many years. As interest rate expectations rise further, US equity multiples are under pressure (Chart 4). Ms. Mea: The recent rise in US bond yields has been largely driven by the real component (TIPS yields), not inflation breakevens. That would usually imply improving US growth prospects. Yet US stocks have corrected as TIPS yields rose. How do you explain this and what should investors expect going forward? Answer: Indeed, the latest rise in US bonds yields is primarily driven by increasing TIPS yields, not inflation breakevens (Chart 5) TIPS yields have not been driven by economic growth expectations in the past couple of years. TIPS yields are breaking out and more upside is likely for reasons unrelated to US economic growth: The Fed’s rhetoric and guidance. TIPS yields typically move with 5-year/5-year forward yields, i.e., expectations for US interest rates in the long run (Chart 6). One of reasons why forward interest rates and TIPS yields have been low is the Fed’s commitment to keep interest rates extremely depressed for so long. As the Fed’s rhetoric has recently changed, so are interest rate expectations and TIPS yields. Given that core inflation will not drop to the Fed’s target range any time soon, the Fed will likely escalate its hawkish rhetoric. Hence, TIPS yields will keep rising, until something breaks. Chart 5US Tips Yields Have Broken Out After A Base Formation Chart 6US TIPS Yields More With Long-Term Interest Rate Expectations TIPS demand/supply and momentum. The TIPS market is relatively small, and it has been rigged by the Fed in the past two years or so. As a part of its QE program, the Fed has been buying a large share of TIPS, and it now owns 22% of this market. As a result, TIPS yields have fallen irrespective of economic growth dynamics. As the QE program ends, the Fed will stop purchasing TIPS. There has also been a rush into TIPS by institutional investors. In a quest for inflation protection when the Fed was complacent about inflation, investors have been opting for TIPS. This has also depressed TIPS yields. As the US central bank sounds more hawkish, investors’ demand for inflation protection will likely diminish. In addition, TIPS prices have recently plunged dramatically. Large losses could prompt further liquidation by investors pushing TIPS yields much higher. All of the above and the fact that TIPS yields remain negative suggest that they will continue rising in the coming months. Chart 7Rising TIPS Yields Warrant A Stronger US Dollar Ms. Mea: Your point that TIPS yields will continue rising in the months ahead irrespective of US inflation and growth dynamics is interesting. So, what are the implications of rising US bond yields, especially TIPS yields, on various financial markets? Answer: Falling/low TIPS yields have benefited long duration plays like US stocks, and especially US growth stocks. Declining TIPS yields were a drag on the US dollar (Chart 7). Finally, they also prompted portfolio capital flows to EM. Consistently, rising TIPS yields will depress share prices in the richly valued equity markets like the US (Chart 4, above) support the greenback, and curtail portfolio flows into EM for a period of time. Ms. Mea: But aren’t US share prices positively correlated with US interest rates? Answer: Not always. Chart 8 illustrates that the correlation between the S&P 500 and US Treasury yields varied over time. Prior to the mid-1960s, it was positive. From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields. Since 1997, US share prices have been positively correlated with US government bond yields (Chart 8, top panel). Chart 8US Stock-Bond Correlation: A Paradigm Shift In 2022? Chart 9Early 2020s = Late 1960s? We believe US markets are now undergoing a major paradigm shift in the stock prices-bond yields correlation. The latter is about to turn negative like it did in the second half of the 1960s. In the mid-1960s, the reason why the stock-to-bond yields correlation turned negative was because US core inflation surged well above 2% in 1966 (Chart 8, bottom panel). This marked a paradigm shift in the relationship between equity prices and US Treasury yields. The same is happening now. As we wrote a year ago in our Special Report titled A Paradigm Shift In The Stock-Bond Relationship, the proper roadmap for the US stock-to-bond correlation is not the last 10 or 20 years, but the second half of the 1960s. After US core CPI surged substantially above 2%, the S&P 500 became negatively correlated with US Treasury yields (Chart 9). Ms. Mea: Let’s now turn to emerging markets. How will EM financial markets perform amid rising US bonds yields? Also, which US yields matter most for EM financial markets, US Treasury yields or TIPS? Answer: Neither US Treasury yields nor TIPS yields have a stable correlation with EM stock prices. Correlations between US nominal bond yields, EM currencies and EM domestic bond yields vary over time. However, US TIPS yields exhibit a reasonably strong positive correlation with mainstream EM local bond yields and the US dollar's exchange rate versus EM currencies (Chart 10). Mainstream EM includes 16 markets but excludes China, Korea and Taiwan. Hence, as US TIPS yields move up, it is reasonable to expect the US dollar to strengthen against mainstream EM currencies and their local bond yields to rise (Chart 10). Currency depreciation and rising domestic bond yields will prove to be toxic for the share prices of these mainstream emerging markets. To sum up, rising US TIPS yields will jeopardize the performance of EM equities, currencies, local rates and credit markets. Ms. Mea: Aren’t many EMs better prepared for rising US nominal/real yields than they were in 2013? Answer: Yes, they are: many EM countries that were running large current account deficits in 2013 now have current account surpluses or small deficits (Chart 11, top panel). Besides, mainstream EMs ramped up their foreign currency debt in the years preceding 2013 while their foreign debt has changed little in the past 6-7 years (Chart 11, bottom panel). Chart 10Rising TIPS Yields Are A Risk To EM Domestic Bonds Chart 11Mainstream EM: Less Vulnerable To The Fed Now Than in 2013 Table 1Current Account Balances In Individual EM Countries Table 1 illustrates the current account balance in individual developing countries. Further, the share of foreign investor holdings in EM local currency bonds has declined a great deal in the past 2 years (Table 2). Finally, many mainstream EM central banks have hiked rates aggressively and their local bond yields have already risen considerably in the past 12 months. These also provide some protection against fixed-income portfolio capital outflows. All in all, vulnerability from foreign portfolio capital outflows in EM is much lower than it was in 2013. Nevertheless, EM financial markets will not remain unscathed if US rates march higher, the US dollar rallies and US stocks wobble. Based on the parameters displayed in Tables 1 and 2, the most vulnerable countries among mainstream EMs are Peru, Colombia, Chile and Egypt. Table 2Foreign Ownership Of Domestic Bonds: January 2022 Versus October 2019 Chart 12China"s Construction Cycle In Perspective Ms. Mea: Let’s now move to your second theme - China’s slowdown. This is well known and arguably priced in financial markets. Importantly, policymakers have been ratcheting up stimulus. Don’t you think now is the time to upgrade the stance on Chinese stocks and China-related plays? Answer: Despite the new round of stimulus, China’s business cycle will continue disappointing over the near-term. As we wrote in last week’s report titled Chinese Equities: Valuations and Profits, Chinese corporate earnings are set to contract in the next 6 months. This means that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive. Importantly, even though property market woes are well known and housing sales and starts have collapsed, housing construction activity has remained resilient (Chart 12). The bottom panel of Chart 12 demonstrates rising completions, which is one of reasons why raw materials prices have been resilient. However, new funding for property developers has dried up and they will be forced to scale back completions/construction activity. Historically, EM non-TMT share prices lagged the turning points in China’s money/credit impulses by several months (Chart 13). Even though the money/credit cycle is now bottoming, a buying opportunity in stocks will likely transpire in a few months. In brief, a tentative bottom in money/credit indicators does not always herald an imminent and sustainable equity rally. Chart 13China"s Credit Cycle And EM Non-TMT Stocks Ms. Mea: Another topic I wanted to discuss today is divergences in global financial markets. Some equity markets have already fallen significantly, while the S&P 500 index as well as a couple of individual EM equity bourses (India, Taiwan and Mexico) have been firm. There have been massive divergences within the US equity market in general and the NASDAQ index in particular. Besides, EM high-yield corporate spreads have widened but EM investment grade corporate spreads remain tight. Finally, commodity prices have remained firm despite both China’s slowdown and US dollar strength. How should investors interpret these divergences? Answer: Such divergences in financial markets often occur during major selloffs. Notable financial market downturns evolve in phases resembling domino effect-like patterns, where some markets lead while others lag. In contrast, corrections are abrupt, and the majority of markets drop concurrently. For example, the EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then spread to Korea, Malaysia and Indonesia, and finally to the rest of Asia. By August 1998, Russian financial markets had collapsed, triggering the Long-Term Capital Management (LTCM) debacle. The last leg of the crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Chart 14Domino Effect In 2007-08 Similarly, the US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 14). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 14, bottom panel). There was a domino effect in financial markets in both the 2015 and 2018 turbulences. Initially, the selloffs started in the weakest links while other parts were holding up. Then, the selloff spread to all without exception. For example, in 2018, US share prices and high-yield credit spreads were doing quite well until October 2018. Then, a broad-based selloff transpired in the fourth quarter of 2018.  Just as chains break at their weakest links, financial market selloffs begin in the most susceptible sectors. Overpriced US stocks with little or no profits and currencies with zero or negative interest rates have been most vulnerable to rising US interest rates. That is why these segments have sold off first in response to rising US nominal and real rates. Our hunch is that the selloff in global markets due to rising US interest rates will broaden in the coming months. This does not mean that global stocks on the verge of a major bear market, but a double-digit drop in global share prices is likely. The last asset class standing will be commodity prices. These will likely be the last affected by rising US interest rates because many investors buy commodities as an inflation hedge. Besides, oil prices have also been supported by the geopolitical tensions around Ukraine and Iran. It might take investor concerns about the US economy and a slowdown in global manufacturing to trigger a relapse in commodity prices. Chart 15Rising TIPS Yields = European Equities Outperforming US Ones Ms. Mea: What investment strategy do you recommend in the coming months? Answer: As US interest rates continue rising and China’s recovery fails to transpire immediately, EM financial markets remain at risk. Therefore, we recommend a defensive stance for absolute return investors in EM equity and fixed income. We are also continuing to short a basket of EM currencies versus the US dollar. As for global equity regional allocation, the outlook for EM performance is less certain than it was in the past 12 months. Clearly, rising US/DM interest rates herald US equity underperformance versus other DM markets, like the euro area and Japan (Chart 15). The basis is that non-US equities are not as expensive as US ones and, hence, are less vulnerable to rising interest rates. Chart 16EM Relative Equity Performance Is Correlated With The USD, Not US Bond Yields Whether EM outperforms or not is mainly contingent on the US dollar, rather than US bond yields. The top panel of Chart 16 demonstrates that EM relative equity performance against DM has a low correlation with US bond yields. Yet, EM equities will underperform their DM peers if the USD strengthens (the greenback is shown inverted on the bottom panel of Chart 16). However, if the greenback depreciates, EM will certainly outperform the US in both equity and the fixed income space. Putting it all together, asset allocators should overweight the euro area and Japan, and underweight the US and EM in a global equity portfolio. Ms. Mea: What about EM local bonds and EM credit markets? Answer: EM credit spreads will widen, and EM local yields will not drop as US bond yields head higher and EM exchange rates depreciate. We continue to recommend investors underweight EM credit versus US corporate credit, quality adjusted. As for local rates, we largely remain on the sidelines of this asset class. Our current recommendations are as follows: receiving 10-year rates in China and Malaysia, paying Czech 10-year rates and betting on 10/1-year yield curve inversions in Mexico and Russia. For a detailed list of our country recommendations for equities, credit, domestic bonds and currencies, please refer to Open Position Tables below. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Highlights Data from the UK revealed it is tantalizingly close to declaring COVID-19 an endemic virus, indicating Britain likely will exit the pandemic ahead of other states soon. The UK is a bellwether market regarding its public-health response to the coronavirus. Some 95% of its population is estimated to carry COVID-19 antibodies (Chart of the Week). Other states – e.g., the US, the EU – have followed the UK with a lag, which we expect will continue. While the Fed's reassurance it will be able to hike rates without disrupting labor markets no doubt encourages markets – and boosted commodity prices – we believe the return to economic normalcy that would be ushed in by endemicity will release pent-up consumer demand for goods and services. This will spur commodity demand. If COVID-19 becomes endemic in enough economies globally, it also would fuel inflation, and inflation expectations.1 Given the tight supplies of industrial commodities – chiefly oil, natural gas and base metals – our assessment of upside price risk is higher now than it was at year-end 2021. We remain long broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index. Feature Fed Chair Powell's confidence that the US central bank will raise rates and keep inflation under control without destabilizing labor markets stole the show earlier this week. The media credited Powell's remarks for the burst of enthusiasm that lifted commodities as an asset class higher. While none would gainsay the Fed's importance to commodity markets, we would point out the approaching endemicity of COVID-19 in the UK – and the likely follow-on from the US and other large commodity-consuming states – is of equal, if not greater, moment. The UK has been out in front on its public-health response to the COVID-19 pandemic and has become a bellwether in the northern hemisphere; the US will follow. This week, the UK's Office for National Statistics (ONS) reported ~ 95% of England's population tested positive for antibodies to COVID-19 via infection or vaccination in the week beginning 29 November 2021. Similar results were reported for Scotland, Wales and Northern Ireland. This is generally observed in all age cohorts tracked by ONS.2 According to David Heymann of the London School of Hygiene and Tropical Medicine, "population immunity seems to be keeping the virus and its variants at bay, not causing serious illness or death in countries where population immunity is high."3 In a briefing hosted by Chatham House this week, Heymann observed, “And probably, in the UK, it’s the closest to any country of being out of the pandemic if it isn’t already out of the pandemic and having the disease as endemic as the other four coronaviruses” currently in circulation, which are responsible for roughly a quarter of common colds.4 Based on UK government data, the ratios of hospitalizations and deaths to COVID-19 cases has been falling precipitously (Chart 2). This is encouraging, given the sharp increase in cases driven by the rapid spread of the omicron mutant, which appears to be rolling over. Medical experts in the UK suggest the data also point to a possible peaking in the omicron surge. This would lighten the load on hospitals, as well as reduce death rates attributed to the coronavirus (Chart 3).5 Return To Normal? Nothing will return commodity markets to economic normalcy faster than endemicity. If this stays on track over the next month or so, it will spur commodity demand sooner rather than later, as pent-up consumer demand for goods and services is discounted by trading markets. If, as the data appear to indicate, the UK's transition from pandemic to endemic COVID-19 is followed by other states like the US and EU a few months later, we would expect a renewed leg up in the post-pandemic commodities rally. This would be apparent in futures contracts, which already are pricing commodity deliveries a month or more hence. Such a turn of events would force us to accelerate our time table for oil-demand recovery, which we expect will come in 2H22. This could restore our $80/bbl forecast for 2022, and lift our 2023 expectation. We also would have to revisit our copper and base metals view, and bring forward the timing of the copper-price rally we expect will lift COMEX refined copper to $4.80/lb and $6.00/bbl in 2022 and 2023, respectively, on average.6 These industrial commodities would see demand increase amid extremely tight supply conditions. Oil markets are tightening on the back of OPEC 2.0's production discipline, and the inability of many member states to fully restore the 400k b/d every month it signed on for beginning in August of last year, owning to production shortfalls outside the core producers of the coalition (Chart 4). Copper, the base-metals bellwether, remains very tight, as seen in balances (Chart 5) and inventories (Chart 6). Chart 4OPEC 2.0s Strategy Works Chart 5Coppers Physical Deficits Will Persist... Chart 6Globally, Exchange Warehouses Tighten China's zero-COVID-19 policy, which has resulted in numerous lock-downs at the local level, has yet to dent oil demand, which, for the time being, is hovering ~ 16mm b/d. We will be updating our oil balances and price forecasts next week, and will have a more extensive analysis of supply-demand balances then. Return Of Speculative Interest Expected With Endemicity Hedge funds have been reducing their exposure to the industrial commodities over the past year, which suggests they either have better alternatives for investing, or did not believe the rallies in commodities over the past year were durable, given the repeated demand shocks visited upon these markets by COVID-19 (Chart 7). We expect that once the pandemic becomes endemic, hedge funds will return to these markets. All the same, given the higher likelihood of price rallies in these markets, we would expect hedge funds to be cited as a cause of higher prices, as typically happens when markets take a sharp leg higher. Regular readers of our research are aware that this generally is not the case – hedge funds follow the news; they don't lead it. This past week we revisited earlier research to see if hedge-fund involvement in commodity markets causes the prices to go up or down to any meaningful degree. And, again, we found no relationship between hedge-fund positioning and the level of commodity prices.7 The presumed influence of hedge funds has been a persistent feature of futures markets in the post-GFC world, following the collapse of commodity prices along with financial markets in 2008. An entire literature has sprung up to explore the influence of these funds on commodity price formation. Below we highlight a few representative articles consistent with our results. Büyüksahin and Harris (2011) show hedge funds and other speculators follow prices – they do not lead them – based on the Granger-causality testing they performed on oil prices and speculative positioning.8 Brunetti et al (2016) argue hedge funds' trading stabilizes markets – i.e., they provide a bid when markets are selling off and an offer when markets are well bid – while swap-dealer trading is uncorrelated with price volatility.9 Knittel and Pindyck (2016) found speculation has reduced volatility in prices since 2004, including during the 2007-08 price run-up.10 Using a straightforward supply-demand-inventory model, they examined cash and storage markets to determine whether speculation had any effect on them or on convenience yields based on cash-vs-futures spreads. They concluded: "We found that although we cannot rule out that speculation had any effect on oil prices, we can indeed rule out speculation as an explanation for the sharp changes in prices beginning in 2004. Unless one believes that the price elasticities of both oil supply and demand are close to zero, the behavior of inventories and futures-spot spreads are simply inconsistent with the view that speculation has been a significant driver of spot prices. If anything, speculation had a slight stabilizing effect on prices." Investment Implications Assuming the UK remains a bellwether for DM economies with reasonably effective vaccine programs, or which have experienced an omicron surge, markets could be close to exiting the COVID-19 pandemic and entering a phase in which the coronavirus is endemic. This would be bullish for demand. And given the extended tightness on the supply side for industrial commodities in particular, it could presage another leg up in prices as economic normalcy returns. We continue to favor broad-based commodity exposure via the COMT ETF, the PICK ETF, and the S&P GSCI index.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US LNG baseload and peak liquification capacity is expected to rise ~ 13% this year to 11.4 Bcf/d and 13.8 Bcf/d (on a December-to-December basis), based on the EIA's latest estimates. The agency's forecast for LNG exports is up 17.3% to 11.5 Bcf/d this year, and 12.1 Bcf/d in 2023. With these increases in baseload and peak export capacity, the US is set to become the largest exporter of LNG in the world this year, in the EIA's estimation. This will be integral to US foreign policy, particularly in markets where the US competes with Russia for export sales, in our estimation. Within North America, US pipeline gas exports to Mexico and Canada are expected to average just under 9 Bcf/d this year, a 5% increase vs. 2021, and 9.2 Bcf/d in 2023. Base Metals: Bullish In China, seasonally low production, as stainless-steel firms undergo maintenance, and the upcoming Winter Olympics in February are keeping steel production subdued. To compound this supply shortage, tight raw material markets, particularly that of iron ore and nickel are buoying steel prices. Heavy rainfall in southern-eastern Brazil is curtailing iron ore production in the region. After Australia, Brazil is the second largest iron ore exporter to China. Nickel prices hit a 10-year high on Tuesday on the back of falling inventories. An LME outage also precipitated the price rise. Dwindling inventories point to increasing demand for the metal as electric vehicle companies ramp-up production and sales this year, particularly in China, where the government stated it will remove EV subsidies by the end of 2022. According to The China Passenger Car Association, EV sales in the country will double to 6 million this year. Precious Metals: Bullish Based on the December FOMC minutes, the markets are now pricing in a more hawkish tilt from the Fed, and expect an initial rate hike by March. The Fed may also shrink its balance sheet soon after the initial rate hike, in line with its expectation the U.S. economy will recover faster this time around. While higher nominal interest rates and tighter monetary policy will increase the opportunity cost of holding gold (Chart 8), the commodity-driven inflation we expect this year – especially if COVID-19 becomes endemic across major economies – will buoy demand for the yellow metal as an inflation hedge. An endemic virus this year will also boost physical gold demand from China and India.       Footnotes 1     Please see More Commodity-Led Inflation On The Way, which we published on 9 December 2021. 2     Please see Coronavirus (COVID-19) latest insights: Antibodies, published by the ONS on December 23, 2021. 3    Please see Covid-19: UK ‘closest of any country in northern hemisphere to exiting pandemic’, published on January 11, 2022 by msn.com. 4    Please see What four coronaviruses from history can tell us about covid-19, published by newscientist.com on April 29, 2020. 5    Please see Omicron may be headed for a rapid drop in US and Britain, published by msn.com on January 11, 2022 published by msn.com. 6    Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. 7     We ran cointegrating regressions – using DOLS and ARDL models – to check for any equilibrium between prices and hedge fund positioning and found none. We looked at the post-GFC period from 2010 to now, since this is the data the US Commodity Futures Trading Commission (CFTC) provides for hedge funds and tested whether hedge-fund positions (in the form of open interest) explained prices vs. the alternative (i.e., prices explain hedge-fund positioning). We again found prices explain position (and not vice versa) for crude oil, natural gas, copper and gold. 8    Please see Büyüksahin, Bahattin and Jeffrey H. Harris (2011),"Do Speculators Drive Crude Oil Futures Prices?" The Energy Journal, 32:2, pp. 167-202. This paper used unique data sets provided by the CFTC. 9    Please see Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), "Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74. 10   Please see Knittel, Christopher R. and Robert S. Pindyck (2016), "The Simple Economics of Commodity Price Speculation," American Economic Journal: Macroeconomics 8:2, pp. 85–110. Investment Views and Themes Strategic Recommendations Trades Closed In 2021

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Table 1Calendar Effects Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US Chart 21Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights US economic data remains robust, but economic surprises are rolling over relative to other G10 countries. Meanwhile, the Fed is turning a tad more hawkish, which is positive for the greenback in the short term but could hurt growth over a cyclical horizon.  A hawkish Fed and dovish PBoC could set the stage for an economic recovery outside the US. We are not fighting the Fed (dollar bullish in the near term), and most of our trades are at the crosses. These include long EUR/GBP, long AUD/NZD and long CHF/NZD. We also have a speculative long on AUD/USD. We were stopped out of our short USD/JPY trade at break even and will look to reinstate at more attractive levels. Feature The dollar was the best performing G10 currency last year (Chart 1), which begs the question if this outperformance will be sustained in 2022. In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Most recently, PMI releases across the developed world have remained robust but are peaking (Chart 2). The key question is whether the slowdown proves genuine, and if so, whether the US can maintain economic leadership versus the rest of the G10. Chart 2AGlobal PMIs Are Softening, Especially In The US Chart 2BGlobal PMIs Are Softening, Especially In The US The next key question is what central banks do about inflation. It is becoming clearer that rising prices are not a US-centric phenomenon but a global problem (Chart 3). Our bias is that central banks cannot meaningfully diverge on the inflation front. This will create trading opportunities. Chart 3AInflation Is A Global Problem Chart 3BInflation Is A Global Problem Over the next few pages, we look at the latest data releases and implications for currency strategy. US Dollar: Strong Now, Weaker Later? The dollar DXY index fell 0.4% in December and is up 0.5% year to date. A growth rotation from the US to other economies continues, even though US economic data over the last month remains rather robust. The latest release of the ISM manufacturing index remained strong at 58.7 for December, but this has rolled over from 61.1 in the previous month. More importantly, the prices paid index fell from 82.4 to 68.2. This suggests inflationary pressures are coming in, which could assuage tightening pressure on the Federal Reserve.  In other data, the trade deficit continues to widen, hitting a record -$97.8bn in November. Durable goods orders for November rose 2.5%, the biggest increase in six months. The consumer confidence index from the Conference Board has also rebounded, rising to 115.8 in December. Home prices are also rising, with an increase of almost 20% year on year in October. This suggests monetary conditions in the US remain very easy, relative to underlying demand. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. The Fed minutes this week highlighted a preference for a faster pace of policy normalization, in the face of a tightening labor market and persistent inflationary pressures. This put the US dollar in a quandary, relative to other developed market currencies. If the US tightens monetary policy, while China eases, it strengthens the dollar in the near term, but tightens US financial conditions that have been the bedrock of US demand. This will suggest peak US demand in the coming months, and a bottoming in demand for countries that are more sensitive to Chinese monetary conditions. Chart 4AUS Dollar Chart 4BUS Dollar The Euro: All Bets On China? The euro was up 0.4% in December. Year-to-date, the euro is down 0.5%. Inflation continues to rise in the eurozone, which begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. PPI came out at 23.7% year-on-year, the highest in several decades. Core consumer price index (CPI) in the eurozone is at 4.9%, a whisker below US levels. Economic data remain resilient in the euro area, despite surging Covid-19 cases. The ZEW expectations survey rose to 26.8 in December from 25.9. The trade balance remains in a healthy surplus (though rolling over). In a nutshell, economic surprises in the eurozone have been outpacing those in the US over the last month. The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their forecasts, inflation is headed below 2% by the end of 2022. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. In the near term, we expect a policy convergence between the ECB and the BoE. As such, we are long EUR/GBP on this basis. Over the longer term, we expect the ECB to lag the Fed, and thus we will fade any persistent strength in the euro. Chart 5AEuro Chart 5BEuro The Japanese Yen: The Most Hated Currency The Japanese yen was down 2% in December. It is also down 0.6% year-to-date. Overall, the yen was the worst performing G10 currency in 2021. Good news out of Japan continues to be underappreciated, while bad news is well discounted. Industrial production rose 5.4% in November, from a contraction the previous month, and the Jinbun Bank manufacturing PMI edged higher in December to 54.3. Retail sales are inflecting higher, and the national CPI has bottomed, easing pressure on the Bank of Japan to remain ultra-accommodative. The bull case for the yen remains intact. First, as we have witnessed recently, it will perform well in a market reset, given it is the most shorted G10 currency. Second, and related, the yen tends to do well with rising volatility, which we should expect in the coming months. Third, Covid-19 infections in Japan remain low, meaning should global cases rollover, Japan could be quicker in jumpstarting an economic recovery. Finally, an equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan, will benefit the yen via the portfolio channel. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models. We were long the yen and stopped out at break even (114.40). We will look to re-enter this trade at more attractive levels. Chart 6AJapanese Yen Chart 6BJapanese Yen British Pound: Near-Term Volatility The pound was up 1.9% in December. Year-to-date, cable is flat. UK data continues to moderate from high levels, similar to the picture in the US. Covid-19 infections continue to surge, but the December manufacturing PMI remains resilient at 57.9. Retail sales and house prices are also robust, and the latest CPI print for November, at 5.1%, justifies the interest rate hike by the Bank of England last month. The near-term path for the pound will be dictated by portfolio flows, and the ability of the BoE to deliver aggressive rate hikes already priced in the market. With the UK running a basic balance deficit, a dry up in foreign capital could hurt the pound. This will also be the case if the BoE does not deliver as many hikes as is discounted by markets. A rollover in energy costs (electricity prices are collapsing), and potentially, inflation could be catalyst. The post-Brexit environment also remains quite volatile.  This short-term hiccup underpins our long EUR/GBP call. Longer term, incoming data continues to strengthen the case for the BoE to tighten policy. At 4.2%, the unemployment rate is at NAIRU. Wages are also inflecting higher. As such, the pound should outperform over the longer-term, as the BoE continues to normalize policy. Chart 7ABritish Pound Chart 7BBritish Pound Australian Dollar: Top Pick For 2022 The Australian dollar was up 2.2% in December. Year-to-date, the Aussie is down 1.4%. Covid-19 continues to ravage Australia, prompting the government to adopt measures such as threatening to deport superstar athletes who refuse to be vaccinated. Combined with the zero-Covid policy in China (Australia’s biggest export partner), the economic outlook remains grim in the near term. In our view, such pessimism opens a window to be cautiously long AUD. First, speculators are very short the currency. Second, low interest rates are reintroducing froth in the property market that the authorities have fought hard to keep a lid on. Home prices in Sydney and Melbourne are rising close to 20% year-on-year. Most inflation gauges are also above the midpoint of the RBA’s target. Our playbook is as follows: China eases policy, allowing Australian exports to remain strong. This will allow the RBA to roll back its dovish rhetoric, relative to other central banks. This will also trigger a terms of trade recovery and interest rate support for the AUD. We are cautiously long AUD at 70 cents, and recommend investors stick with this position. Chart 8AAustralian Dollar Chart 8BAustralia Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar was up 0.25% in December, while down 1.1% year to date. The Covid-19 situation is much better in New Zealand, compared to its antipodean neighbor, but recent economic developments still have a stagflationary undertone. Headline CPI and house prices are rising at the fastest pace in decades, but wage growth remains very muted. With the RBNZ that now has house price considerations in its mandate, the risk is that further rate hikes hamper the recovery. Data wise, the trade balance continues to print a deficit as domestic demand in China remains tepid. New Zealand currently has the highest G10 10-year government bond yield, suggesting marginally tighter financial conditions. Meanwhile, portfolio flows into New Zealand have turned negative in recent quarters, especially driven by defensive equity outflows. Overall, the kiwi will benefit from a recovery in China but less so than the AUD, which is much shorted and has a better terms of trade picture. As such we are long AUD/NZD. Chart 9ANew Zealand Dollar Chart 9BNew Zealand Dollar Canadian Dollar: Next Up After AUD? The CAD was up 1.4% in December. Year to date, the loonie is down 0.7%. The key driver of the CAD in 2022 remains the outlook for monetary policy, and the path of energy prices. We are optimistic on both fronts. On monetary policy, CPI inflation remains above the central bank’s target, house prices are rising briskly, and the trade balance continues to improve meaningfully. This provides fertile ground for tighter monetary settings. Employment in Canada is already above pre-pandemic levels and has now settled towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs (27,500 in December), is in line with trend. The unemployment rate continues to drop, hitting 6.0%. Oil prices also remain well bid, as outages in Libya offset planned production increases by OPEC. Should Omicron also fall to the wayside, travel resumption will bring back a meaningful source of demand. Net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. We are buyers of CAD over a 12–18-month horizon. Chart 10ACanadian Dollar Chart 10BCanadian Dollar Swiss Franc: Line Of Defense The Swiss franc was up 0.8% in December and has fallen by 0.9% year to date. The Swiss economy continues to fare well amidst surging Covid-19 infections. Meanwhile, as a defensive currency, the franc has benefitted from the rise in volatility, especially compared to other currencies like the New Zealand dollar over the course of 2021 (we are long CHF/NZD). Economic wise, the unemployment rate has dropped to 2.5%, inflation is rising briskly, and house prices remain very resilient. This is lessening the need for the central bank to maintain ultra-accommodative settings. It is also interesting that the Swiss franc is well shorted by speculators engaging in various carry trades. Our baseline is that the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. That said, this is well baked in the consensus suggesting any risk-off event or pricing of less monetary accommodation in other markets will help the franc. One area of opportunity is being long EUR/CHF, where the market has priced a very dovish ECB, even relative to the SNB. We are long this cross (which could suffer in the short term) but should rise longer term.  Chart 11ASwiss Franc Chart 11BSwiss Franc Norwegian Krone: A Beta Play On A Lower Dollar The Norwegian krone was up 2.7% in December and is down 0.9% year to date. Norway was a developed market beacon of how to handle the pandemic until the more contagious Omicron variant started to ravage the economy. The latest data prints suggest core CPI is falling and house price appreciation is rolling over. Headline inflation remains strong, and the latest retail sales release shows 1% growth month on month for November suggesting some resilience amidst the pandemic. The Norges Bank has been the most orthodox in the G10, raising interest rates and promising to continue doing so in the coming quarters. Should Omicron prove transient and oil prices stay resilient, this will be a “carte blanche” for the Norges bank to keep normalizing policy.  Norway’s trade balance and terms of trade remain robust. Meanwhile, portfolio investment in some unloved sectors in Norway could provide underlying support for the NOK. We are buyers of the NOK on weakness. Chart 12ANorwegian Krone Chart 12BNorwegian Krone Swedish Krona: A Play On China The SEK was up 0.3% in December and is down 1% year to date. The performance of the Swedish economy continues to strengthen the case for the Riksbank to tighten monetary policy. In recent data, the trade balance remains in a surplus as of November, household lending is rising 6.6% year on year (November), retail sales remain robust, and PPI is inflecting higher. Manufacturing confidence also improved in December, along with improvement in labor market conditions.  The Riksbank will remain data dependent, but it has already ended QE. It remains one of the most dovish G10 central banks and is slated to keep its policy rate flat at 0% at least until 2024. This could change if inflationary pressures remain persistent. A bounce in Chinese demand could be the catalyst that triggers this change.  We have no open positions now in SEK, but will look to go short USD/SEK and EUR/SEK should more evidence of a Swedish recovery materialize. Chart 13ASwedish Krona Chart 13BSwedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights Demand in the major economies remains well below its pre-pandemic trend. Meaning that relative to potential output, demand is lukewarm, at best. Inflation is hot, not because of strong overall demand, but because of the surging demand for goods. If the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Underweight personal goods versus consumer services. Bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market and the $100 trillion global equity market. Long-term investors should continue to own US T-bonds and focus their equity investments in long-duration (growth) stocks, sectors, and stock markets… …because the ultimate low in bond yields is yet to come. Feature Chart of the WeekWill Bond Yields Stay Chilled With Inflation So Hot? 2022 begins with an investment conundrum. Why have long bond yields been so chilled when inflation is running so hot? (Chart I-1) While US and UK inflation have ripped to 6.9 percent and 5.1 percent respectively, the 30-year T-bond yield and 30-year gilt yield remain a relative oasis of calm – standing at 2.1 percent and 1.2 percent respectively. 10-year yields have also stayed relatively calm. Moreover, as long-duration bonds set the valuations of long-duration stocks, a calm bond market has meant a calm stock market. What can explain this apparent conundrum of chilled yields in the face of the hottest inflation in a generation? Long Bond Yields Are Tracking Demand, Not Inflation Chart I-2 answers the conundrum. The long bond yield is taking its cue not from hot inflation, but from economic demand, which is far from overheating. Quite the contrary, US real GDP and consumption are struggling to reach their pre-pandemic trends. Meanwhile, UK real GDP languishes 5 percent below its pre-pandemic trend (Chart I-3), and other major economies tell similar stories. Chart I-2Long Bond Yields Are Tracking Demand Chart I-3Demand Is Lukewarm, At Best Some people mistake the strong economic growth in recent quarters for overheating demand. In fact, this robust growth is just the natural snap-back after the pandemic induced collapse in early-2020. Meaning that the strong growth is unsustainable, just as the bounce that a ball experiences after a big drop is unsustainable. Demand in the major economies remains well below its pre-pandemic trend. To repeat, demand in the major economies remains well below its pre-pandemic trend. As this pre-pandemic trend is a good gauge of potential output, economic demand is lukewarm, at best. And this explains why long bond yields have remained chilled. Inflation Is Tracking The Displacement Of Demand Yet solving the first conundrum simply raises a second conundrum. If overall demand is lukewarm, then why is inflation so hot? (Chart I-4). The answer is that inflation is being fuelled by the displacement of demand into goods from services (Chart I-5). Chart I-4Hot Inflation Is Not Reflecting Lukewarm Overall Demand Chart I-5Hot Inflation Is Reflecting The Hot Demand For Goods If a dollar spent on goods is displaced from a dollar spent on services, then overall demand will be unchanged. However, what happens to the overall price level depends on the relative price elasticities of demand for goods and services. If the price elasticities are the same, then overall prices will also be unchanged, because a higher price for goods will be exactly countered by a lower price for services. But if the price elasticities are very different, then overall prices can rise sharply because the higher price for goods will dominate overall inflation. All of which solves our second conundrum. Spending on services that require close contact with strangers – using public transport, going to the dentist, cinema, or recreational activities that involve crowds – are suffering severe shortfalls compared to pre-pandemic times. Some people say that this is due to supply shortages, yet the trains and buses are running empty and there is no shortage of dentists, cinema seats, or even (English) Premier League tickets. Indeed, the Premier League team that I support (which I will not name) has been sending me begging emails to attend matches! Surging inflation is no longer a reliable reflection of overall demand. If somebody doesn’t use public transport, or go to the cinema or crowded events because he is worried about the health risk, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In other words, the price elasticity of demand for certain services has flipped from its usual negative to zero, or even positive.   This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging inflation is no longer a reliable reflection of overall demand, which remains below its potential. Instead, surging inflation is largely reflecting the surging demand for goods. Two Ways That Inflation Can Resolve: One Good, One Bad It follows that if the spending on goods cools, then inflation will also cool. We expect this ‘good’ resolution of inflation to unfold, because there are only so many goods that any person can buy. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. We recommend that equity investors play this inevitable normalisation by underweighting personal goods versus consumer services. Still, the resolution of inflation could also take a ‘bad’ form. If inflation persisted, then bond yields could lose their chill as they flipped their focus from lukewarm demand to hot inflation. Given that long-duration bonds set the valuations of long-duration stocks, and given that stock valuations are already stretched versus bonds, this would quickly inflict pain on stock investors (Chart I-6). Chart I-6The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits More significantly, it would also quickly inflict pain on the all-important real estate market. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent1 (Chart I-7). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields (Chart I-8). Chart I-7The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion… Chart I-8…And The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields This means that bond yields have the scope to rise by just 50-100 bps before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, the massive deflationary backlash would annihilate any lingering inflation. Some people counter that in an inflationary shock, stocks and property – as the ultimate real assets – ought to perform well even as bond yields rise. However, when valuations start off stretched as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. The scope for higher bond yields is limited by the fragility of stock market and real estate valuations. With the scope for higher yields limited by the fragility of stock market and real estate valuations, and with the ultimate low in yields yet to come, long-term investors should continue to own US T-bonds. And they should focus their equity investments in long-duration (growth) stocks, sectors, and stock markets. Fractal Trading Update Owing to the holidays, we are waiting until next week to initiate new trades. We will also add a new feature – a ‘watch list’ of investments that are approaching potential turning points, but are not yet at peak fragility. We believe that this enhancement will help to prepare future trades. Stay tuned.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations ​​​​

We have entered a new phase of the cycle, with central banks in most developed markets turning more hawkish (the Bank of England surprisingly hiking in December, and the Fed signaling three rate hikes for 2022). How much does this matter for equities and other risk assets? Our view is that, as long as economic growth continues to be strong (and we think it will), and provided that central banks don’t overdo the tightening (and, with inflation likely to come down this year, we think excess tightening is unlikely), the hawkish turn might temporarily raise volatility and cause the occasional correction, but it does not undermine the case for equities to outperform bonds over the next 12 months. We remain overweight global equities. Economic growth is likely to continue to be well above trend for the next year or two (Chart 1), driven by (1) consumers spending some of the $5 trillion of excess savings they have accumulated in the G10 economies, (2) the unprecedented wealth effect from recent stock and house price rises (Chart 2), and (3) strong capex as companies strive to increase capacity to meet the consumer demand (Chart 3). The upsurge in Covid cases in December (Chart 4) will undoubtedly slow growth temporarily. But the signs are that the now-prevalent Omicron variant is mild, and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity, though emerging countries – especially China – may continue to struggle. Chart 1Growth Will Continue To Be Above Trend Chart 2Growth Will Be Boosted By The Wealth Effect... Chart 3...And Capex To Increase Production With US growth very strong – the Atlanta Fed Nowcast suggests Q4 QoQ annualized real GDP growth was 7.6% – and core PCE inflation 4.1%, it is hardly surprising that the Fed wants to accelerate the rate at which it withdraws accommodation. The FOMC dots, which see three rate hikes this year and another three in 2023, are unexceptional and close to what the futures market has already been (and still is) pricing in (Chart 5). Chart 4Covid Cases Not Leading to Hospitalizations And Deaths Chart 6Fed Hikes Have Usually Caused Only A Short-Lived Selloff Chart 5The Futures Market Is In Line With The FOMC Dots         In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks (the timing depending on how well the hike was flagged in advance), but the equity market digested the news rapidly, quickly resuming its upward trend as the Fed continued to tighten (Chart 6). The same was true around the tapering and end of asset purchases in 2013-17 (Chart 7). All that depends, though, on whether the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfil, causing shortages. This can be seen in the very different pattern of goods and services inflation (Chart 8). As we have argued previously, the supply response is now kicking in for key inputs into manufactured goods, such as semiconductors and shipping and, with demand likely to shift to services this year as the pandemic fades, this should bring inflation down. Chart 7Tapering Didn't Much Affect Stocks Either Chart 8Inflation Probably Will Decline This Year That said, the year-on-year inflation number will continue to look scary for some time, even if month-on-month inflation settles back to its pre-pandemic level of 0.2% (Chart 9). The consensus average forecast of 3.3% core PCE inflation in 2022 is factoring in monthly inflation around this level. The risks to inflation remain to the upside, particularly if wages respond to higher prices (US wage growth is currently 4-6%, significantly lagging behind price inflation – Chart 10), causing companies to raise prices further, triggering a price-wage spiral. Chart 9Year-On-Year Inflation Will Remain High Chart 10Risk Of A Price-Wage Spiral? All this suggests a year of significant volatility and uncertainty. The US stock market has not seen a correction (a drop of more than 10%) in this cycle, and there were no drawdowns last year of more than 5% (Chart 11). This is unusual: There were six 10%-plus corrections in the 2009-2019 bull market. The US equity rally is also looking increasingly narrow, with the run-up to a record-high in December driven by just a few large-cap growth stocks (Chart 12). This – and pricey valuations – makes it vulnerable and, as a hedge to downside risks, we continue to recommend an overweight in cash (rather than government bonds, which offer very asymmetrical returns, with significant downside in the event that inflation proves to be stubborn). Chart 11Where Have All The Corrections Gone? Chart 12Stock Market Has Got Very Narrow The other policy focus remains China. The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become (Chart 13). A slight loosening of monetary policy has probably caused credit growth to bottom (Chart 14). However, our China strategists argue that the easing is likely to be only moderate since policymakers want to continue with structural reforms, such as reducing debt. The next few months may resemble early 2019 when the PBOC engineered a brief injection of liquidity which lasted only a few months. Moreover, the slump in the property market has not run its course (Chart 15), and this will hamper the authorities’ ability to accelerate infrastructure spending, much of which is financed by local governments’ property sales. Even if Chinese credit growth and the property market do pick up a little, the economy – and indeed commodity prices – will not bottom for another 6-9 months (Chart 16). But, when this happens, it would be a signal to turn more risk-on and bullish on cyclical countries and sectors, such as Emerging Markets, Europe, and Value stocks. Chart 13Chinese Data Looks Very Poor Chart 14Is Credit Growth Now Bottoming? Chart 15Slump In China Property Is Not Over Chart 16It Will Take A While For Commodity Prices To Pick Up Equities: While we remain overweight equities, returns this year will be only modest. Returns in 2020 were driven by multiple expansion, and last year by strong margin expansion (Chart 17), as often happens in Years 1 and 2 of a bull market. But this year, while sales growth should remain strong, BCA Research’s US equity strategists’ model points to a small decline in margins, which are at a record high (Chart 18). The PE multiple is likely to fall further too, as it usually does when the Fed is hiking. Even with buybacks and dividends, this amounts to a total return from US equities of only about 8%. Chart 17What Can Drive Returns In 2022? Chart 18Margins Likely To Slip From Record High Chart 19Europe Is More Sensitive To China Slowing... Nonetheless, we continue to prefer the US to other developed markets. Europe is more sensitive to the slowdown in China (Chart 19) and tends to underperform when global growth is slowing and is concentrated in services. Neither is it notably cheap versus the US relative to history (Chart 20). Emerging Markets face multiple headwinds, from the slowdown in China, to rampant inflation that is forcing central banks to hike aggressively (Brazil, for example has raised rates to 9.25% from 2% since April even in the face of weak growth and continuing risks from Covid). Chart 20...And Not Particularly Cheap Chart 22US Treasurys Are Attractive to Europeans And Japanese Chart 21Long Rates Low Given Fed Signaling Fixed Income: Long-term rates are surprisingly low, given the hawkish pivot of the Fed and other central banks (Chart 21). One explanation Fed chair Powell has given is the attractiveness of US Treasurys, after FX hedges, to European and Japanese investors (Chart 22). He is correct about this, but the advantage will wane as the Fed raises rates (while the ECB and BOJ don’t). We continue to forecast the 10-year Treasury yield to rise to 2-2.25% by the time of the first Fed hike. We are underweight duration and expect a moderate steepening of the yield curve. TIPs look richly valued, especially at the short end. We are neutral on US TIPs, where 10-years at least represent a hedge against tail-risk inflation. Inflation-linked bonds in the euro zone are particularly unattractive now (Chart 23).     Chart 23Breakevens Already Pricing In A Lot Of Inflation In credit, we continue to see value in riskier high-yield bonds, where US B- and Caa-rated names are trading at breakeven spreads close to historic averages (Chart 24). Our global fixed-income strategists have also recently turned more positive on US dollar-denominated EM debt, which offers a decent spread pickup versus US corporate debt of the same credit rating and maturity (Chart 25). Currencies: Relative monetary policy between the US and Europe and Japan could mean some further upside for the dollar over the next few months (Chart 26). However, the dollar is expensive relative to fair value, long-dollar is an increasingly crowded trade and, in the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD. Chart 25...As Are Some EM Dollar Bonds Chart 26Dollar To Rise On More Hawkish Fed? Chart 28Gold Is Vulnerable To Rising Real Rates Commodities: Metals prices are likely to suffer further in the first half of the year, as China’s growth continues to slow. This would suggest a further decline in the equity Materials sector. Nonetheless, we continue to have a neutral on commodities as an asset class because of the positive long-term story: Demand for metals for use in alternative energy is not being met by increased supply because investor pressure is stymying capex in the mining sector (Chart 27). It makes sense to have long-term exposure to metals such as copper and lithium which are used in electric vehicles. The oil price is mostly determined currently by Saudi supply. Our energy strategists forecast Brent oil to average $78.50 in 2022 and $80 in 2023, roughly the same as the current spot price. We remain neutral on gold: The bullion is not particularly attractively valued currently and will suffer if, as we expect, real long-term rates rise (Chart 28). Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Recommended Asset Allocation 

Bank Credit Analyst

As 2021 draws to a close, we thank you for your ongoing readership and support. We wish you and your loved ones a happy holiday season and all the best for a healthy and prosperous 2022. Highlights Over the coming three months, the odds are high that the Omicron variant of COVID-19 will disrupt economic activity in advanced economies, but the magnitude of the disruption will be heavily determined by the variant’s capacity to produce severe illness. For now, we remain of the view that the pandemic will recede in importance over the course of the next year. Relative to the assessment that we published in our 2022 Outlook report, the Omicron variant of COVID-19 has modestly raised the odds of a stagflationary outcome next year. Our base case view of above-trend growth and above-target inflation remains the most likely scenario for 2022. We do not think that the actual risk of a recession has risen significantly since we published our annual outlook, but we can envision a scenario in which Fed tightening causes investors to become fearful of a recession. The true risk of a monetary policy-induced recession over the coming 12-18 months will only rise if long-dated inflation expectations break above the range that prevailed prior to the Global Financial Crisis. Beyond 2022, the main risk to financial markets is that investors raise their longer-term interest rate expectations closer to the trend rate of economic growth. This would not be bad news for real economic activity, but it would imply meaningfully lower prices for financial assets that have benefited from low interest rates. We continue to advise that investors position themselves in line with the investment recommendations that we presented in our Outlook report. Over the coming year, investors should watch for the following when deciding whether to reduce exposure to risky assets: a breakout in long-dated inflation expectations, a significant flattening in the yield curve, or a rise in 5-year, 5-year forward US Treasury yields above 2.5%. Feature Our recently published 2022 Outlook report laid out the main macroeconomic themes that we see driving markets next year, as well as our cyclical investment recommendations.1 In this month’s report, we discuss the most relevant risks to our base case view in more depth, and update our fixed-income view in the wake of the December FOMC meeting. The Near-Term Risks Chart I-1DM Policymakers Are Afraid That Omicron Will Overwhelm The Medical System Over the coming 0-3 months, the greatest risks to economic growth stem from the likely impact of the Omicron variant of COVID-19 on the medical system and the evolution of Europe’s energy crisis. News about the Omicron variant emerged just a few days prior to the publication of our annual outlook, and considerable uncertainty remains about its impact. Some early evidence suggests that the variant causes less severe disease, with a recent press release from South Africa’s largest private health insurance administrator suggesting that the risk of hospital admission was 29 percent lower for adults with the Omicron variant after adjusting for age, sex, underlying health conditions, and vaccine status. More recent studies from South Africa have suggested a much larger reduction in the severity of disease,2 but it is not yet clear whether these findings are applicable to advanced economies,given South Africa’s more recent vaccination campaign and higher proportion of a previously infected population. If Omicron turns out to result in 30 percent less hospitalizations, that only reduces the net impact on the medical system if the Omicron variant is no more than 1.5x as transmissible as the Delta variant. The sheer speed at which Omicron is spreading suggests it is far more contagious than this, the result in part to its ability to evade two-dose immunity. The potential for Omicron to quickly overwhelm available health system resources has alarmed authorities in several advanced economies, especially given that cases and hospitalizations have already trended higher in several countries even while Delta remained the dominant variant (Chart I-1). Additional restrictions on economic activity in the DM world appear to be likely over the coming weeks, and may be in effect until booster doses have been fully administered and/or Pfizer’s drug Paxlovid becomes widely available. For Europe, a worsening of the COVID situation has the potential to exacerbate the economic impact of the region’s ongoing energy crisis. Chart I-2 highlights that European natural gas prices have again exploded, reaching a new high that is fourteen times its pre-pandemic level. We noted in our Outlook report that European natural gas in storage is well below that of previous years, and Chart I-3 highlights that the gap in stored gas relative to previous years persists. This is occurring despite roughly average temperatures in central Europe over the past month (Chart I-4), underscoring that, barring atypically warmer temperatures, European natural gas prices are likely to remain elevated throughout the winter. Chart I-2Another Explosion In European Natural Gas Prices Chart I-5For Europe, COVID Is More Of A Problem Than Natural Gas Prices   For now, it appears that the rise in COVID cases is having a more pronounced effect on the European economy than the energy price situation. Chart I-5 highlights that the flash December euro area manufacturing PMI fell only modestly, and that Germany’s manufacturing PMI actually rose in December. By contrast, the euro area services PMI fell over two points, reflecting the toll that recent pandemic control measures have taken on non-goods producing activity. Over the coming three months, the odds are high that the Omicron variant will disrupt economic activity in advanced economies to some degree, but the magnitude of the disruption will be heavily determined by the variant’s capacity to produce severe illness. Investors will have more information on hand in a few weeks by which to judge the extent of this risk. We will provide an update to our own assessment in our February report. Risks Over The Next Year In our Outlook report, we assigned a 60% chance to an above-trend growth and above-target inflation scenario next year, a 30% chance to a “stagflation-lite” scenario of growth at or below potential and inflation well above target, and a 10% chance of a recession. We present below our assessment of the risk that one of the latter two scenarios occurs in 2022. The Risk Of “Stagflation-Lite” Chart I-6Aside From Europe's Energy Crisis, Supply-Side Constraints Are Slowly Easing The Omicron variant of COVID-19 has modestly raised the odds of a stagflationary outcome next year. Over the past few months, supply-side pressures have been modestly improving outside of Europe. Chart I-6 presents our new BCA Supply-Side Pressure Indicator, which measures the impact of supply-side restrictions across four categories: energy prices, shipping costs, the semiconductor shortage impact on automobile production, and labor availability. When we include all eleven components, the index has been trending higher of late, but trending flat-to-down after excluding European natural gas prices. While Omicron has the potential to reduce energy price pressure outside of Europe, it has the strong potential to cause a further increase in global shipping costs and postpone US labor market normalization. On the shipping cost front, we noted in our Outlook report that supply-side effects have been a significant driver of higher costs this year. The large rise in China/US shipping costs since late-June has been seemingly caused by the one-month closure of the Port of Yantian that began in late-May. While China has made enormous progress in vaccinating its population over the course of the year, and has prioritized the vaccination of workers in key industries, recent reports suggest that the Sinovac vaccine provides essentially no protection against contracting the Omicron variant of COVID-19. It is possible that Sinovac will offer protection against severe illness, but in terms of preventing transmission of the disease, Omicron has essentially returned China’s vaccination campaign back to square one. Chart I-7Further Price Increases May Seriously Slow Goods Spending That fact alone makes it almost certain that China will maintain its zero-tolerance COVID policy for most of 2022, which significantly raises the risk of additional factory and port shutdowns – and thus even higher shipping costs and imported goods prices. One optimistic point is that these shutdowns are more likely to occur in mainland China than in Taiwan Province or Malaysia, two key semiconductor exporters. This is because these two regions have distributed doses of Pfizer’s vaccine, and thus presumably have the ability to provide three-dose mRNA protection to workers in crucial exporting industries (should policymakers choose to do so). Still, US consumer goods prices would clearly be impacted by even higher shipping costs, which would likely have the combined effect of slowing growth and raising prices. Chart I-7 highlights that the recent sharp deterioration in US households’ willingness to buy durable goods has been closely linked to higher goods prices, arguing that goods spending may slow meaningfully if prices rise further alongside renewed weakness in services spending. Omicron’s contagiousness may also exacerbate the ongoing US labor shortage. The shortage has occurred because of a surge in the number of retirees, difficult working conditions in several industries, and increased childcare requirements during the pandemic. The increase in the number of retirees has not happened for structural reasons; it has been driven by a sharp slowdown in the number of older Americans shifting from “retired” to “in the labor force”, which has occurred because of health concerns. None of these factors are likely to improve meaningfully while Omicron is raging, suggesting that services prices are likely to remain elevated or accelerate further even if services spending falls anew. To conclude on this point, we estimate that the odds of a stagflation-lite scenario have risen to 35% (from 30%), and the odds of our base-case scenario of above-trend growth and above-target inflation have fallen to 55% (Chart I-8). Still, our base-case view remains the most probable outcome, given that we do not believe the odds of a recession next year have risen. The Risk Of Recession We do not think that the actual risk of a recession has risen significantly since we published our annual outlook, but we can envision a scenario in which Fed tightening causes investors to become fearful of a recession. Such a scenario would have a material impact on cyclical investment strategy, and thus warrants a discussion. Following the December FOMC meeting, BCA’s baseline expectation is that a first Fed hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. BCA’s house view on this question is now in line with the view of The Bank Credit Analyst service, which published in a September Special Report that the Fed could hit its maximum employment objective as early as next summer.3 The Fed’s shift implies that the 2-year yield should rise to 1.85%, and the 10-year yield to 2.35%, by the end of next year (Chart I-9).  Chart I-9A More Hawkish Fed Means A 2.35% 10-Year Yield Next Year We doubt that US monetary policy will become economically restrictive next year. If the Omicron variant of COVID-19 causes a serious slowdown in economic activity, the Fed will ramp down its expectations for rate hikes. And if the Fed meets our baseline expectations for hikes next year in the context of above-trend economic growth, we do not believe that a 2.35% 10-year Treasury yield will be, in any way, limiting for economic activity. However, investors do not agree with our view about the boundary between easy and tight monetary policy, and may begin to fear a recession in response to Fed tightening next year. We noted in our Outlook report that we believe the neutral rate of interest (“R-star”) is likely higher that investors believe, but the fact remains that the Fed and market participants have judged, with deep conviction, that the neutral rate remains very low relative to the potential growth rate of the economy. Chart I-10 presents the fair value path of the 2-year Treasury yield based on our expectations for the Fed funds rate, alongside the actual 10-year Treasury yield. The chart highlights that the 2/10 yield curve could flatten significantly or even invert in the second half of 2022 if long-maturity yields rise only modestly in response to Fed tightening, which could occur if investors focus on the view that the neutral rate of interest is low and that Fed rate hikes will not prove to be sustainable. Based on two different measures of the yield curve, fixed-income investors believe that the current economic expansion is already 50-60% complete (Chart I-11), implying a recession at some point in the first half of 2023. Chart I-10The US Yield Curve Could Invert Next Year If Long-Maturity Yields Rise Only Marginally Chart I-11More Than Half Of The Economic Expansion Has Already Occurred, According To The Yield Curve Chart I-12A Serious Flattening In The Yield Curve Could Unnerve Stocks If the yield curve were to flirt with inversion and investors began to price in the potential for a recession, it would cause significant financial market turmoil regardless of whether the risk of recession is real or not. Chart I-12 highlights that the S&P 500 fell 20% in late 2018 as the 2/10 yield curve flattened towards 20 basis points, in response to the economic impact of the China-US Trade War and the global impact of US tariffs on the auto industry. So it is possible that a “recessionary narrative” negatively impacts risky asset prices in the second half of 2022, even if an actual recession is ultimately avoided. Based on this, we would be much more inclined to reduce our recommended exposure to equities if the US 2/10 yield curve were to flatten below 30 basis points next year. In our view, the risk of a monetary policy-induced recession over the coming 12-18 months will only legitimately rise if long-dated inflation expectations break above the range that prevailed prior to the Global Financial Crisis. We noted in our Outlook report that this has not yet occurred for either household or market-based expectations, although it is a risk that cannot be ruled out. The odds of a breakout in long-dated inflation expectations will rise the longer that actual inflation remains elevated, and our inflation probability model suggests that core PCE inflation will remain well above 3% next year and potentially above 4% – although Chart I-13 highlights that the odds of the latter are falling. Chart I-13US Core Inflation Will Remain Well Above Target Next Year A dangerous breakout in inflation expectations would raise the risk of a recession because of the Fed’s awareness of the “sacrifice ratio”, a very important economic concept that has been mostly irrelevant for the past 25 years. The sacrifice ratio is an estimate of the amount of output or employment that must be given up in order to reduce inflation by one percentage point. Table I-1 highlights some academic estimates of the sacrifice ratio, which have typically varied between 2-4% in output terms. For comparison purposes, real GDP has typically fallen no more than 2% on a year-over-year basis during most post-war US recessions. Real GDP growth fell 4% year-over-year in 2009, highlighting that the cost of reducing the rate of inflation by 1 percentage point is effectively a severe recession. In his Senate testimony in late-November, Fed Chair Jay Powell noted that persistently high inflation threatens the economic recovery. He also implied that to reach its maximum employment goal, the Fed may need to act pre-emptively to tame inflation. This was implicit recognition of the sacrifice ratio, and should be seen as an expression of the Fed’s desire to avoid a scenario in which persistently high inflation causes inflation expectations to become unanchored (to the upside), as it would force the Fed to sacrifice economic activity in order to ensure price stability. By acting earlier to normalize monetary policy, the Fed hopes to keep inflation expectations well contained. Chart I-14Long-Dated Market-Based Inflation Expectations Are Not Out Of Control For now, we see no signs that the Fed will fail to keep inflation expectations from rising dangerously. Chart I-14 highlights that long-dated market expectations for inflation have been falling over the past two months, and are essentially at the same level that they were on average in 2018. Given this, we maintain the 10% odds of recession that we presented in our Outlook report, although investors will need to monitor inflation expectations closely over the coming year to judge whether the risks of a monetary policy-induced recession are indeed rising. Risks Beyond The Next Year Beyond 2022, the main risk to risky asset prices is probably not overly tight monetary policy. Instead, the risk is that investors will come to the conclusion that the Fed funds rate will ultimately end up rising above what the Fed is currently projecting, and that the economy will be capable of tolerating interest rates that are closer to the prevailing rate of economic growth. This would not be bad news for real economic activity, but it would imply meaningfully lower prices for financial assets that have benefited from low interest rates. Chart I-15US Stocks Would Suffer Significant Losses If Interest Rates Rise Towards Potential Growth Chart I-15 drives the point home by comparing the current S&P 500 forward P/E ratio to a “justified” P/E. Here, we calculate the justified P/E using the average ex-ante equity risk premium (ERP) since 1980, and real potential GDP growth as a stand-in for the real risk-free rate of interest. The chart highlights that US stocks would experience a 30% contraction in equity multiples should real long-maturity bond yields approach 2%. A decline in the ERP could potentially reduce losses for equity holders in a higher interest rate scenario, but it is very likely that the net effect would still be negative for stocks. We detailed in our Outlook report why we believe that the neutral rate of interest is higher than most acknowledge. We agree that R-star fell in the US for a time following the Global Financial Crisis (GFC), but we strongly question that it is as low as the Fed and investors believe. The neutral rate of interest fell during the first half of the last economic cycle because of a persistent period of household deleveraging and balance-sheet repair, which was a multi-year consequence of the financial crisis and the insufficient fiscal response to the 2008-09 recession. We highlighted in our Outlook report that US household balance sheets have been repaired, and that the household debt service ratio has fallen to mid-1960s levels. However, Chart I-16 highlights that even the corporate sector, which has leveraged itself significantly over the past decade, has seen its debt service ratio plummet. In a scenario in which long-maturity Treasury yields were to rise to 4%, we estimate that the debt service burden of the nonfinancial corporate sector would rise to its 70th-80th percentile historically. Chart I-16The US Corporate Sector Debt Service Burden Has Room To Rise That would be a meaningful increase from current levels, but it would not be unprecedented, and thus would not render a 4% 10-year Treasury yield to be economically unsustainable. In addition, we strongly suspect that corporations would reduce their interest burden in such a scenario by issuing equity to retire debt. That would lower firms’ debt burden and reduce the economic impact of higher interest rates, although it would be additionally negative for equity investors given that this would dilute earnings per share. We argued in our Outlook report that a shift in investor expectations about the neutral rate of interest is unlikely to occur before the Fed begins to normalize monetary policy. Ryan Swift, BCA’s US Bond Strategist, presented further evidence of this perspective in a Special Report earlier this week.4 Ryan highlighted results from a recent academic paper, which showed that the entire decline in the 10-year Treasury yield since 1990 has occurred during three-day windows centered around FOMC meetings (Chart I-17). Ryan argued that this suggests investors change their neutral rate expectations in response to Fed interest rate decisions, rather than in response to independent macroeconomic factors that are distinct from monetary policy action. This argues that a shift in neutral rate expectations is unlikely before the Fed begins to lift interest rates in the middle of the year, and probably not until the Fed has raised rates a few times. We are thus unlikely to recommend that investors reduce their equity exposure in response to this risk until 5-year, 5-year forward Treasury yields break above 2.5% (the Fed’s long-run Fed funds rate projection), which is 80 basis points above current levels (Chart I-18). Chart I-17Fed Rate Decisions Drive Long-Maturity Bond Yields Chart I-18We Will Consider Selling Stocks If Market-Based Neutral Rate Estimates Exceed 2.5%   Investment Conclusions We continue to advise that investors position themselves in line with the investment recommendations that we presented in our Outlook report. Over the following 12-months, we expect the following: Global stocks to outperform bonds Short-duration fixed-income positions to outperform long High-yield corporate bonds to outperform within fixed-income portfolios Value stocks to outperform growth Non-resource cyclicals to outperform defensives Small caps to outperform large A modest rise in commodity prices led by oil A decline in the US dollar However, our discussion of the risks to our views has highlighted three things for investors to monitor next year when deciding whether to reduce exposure to stocks (and risky assets more generally): A breakout in long-dated inflation expectations, as that would likely cause the Fed to raise interest rates more aggressively than it currently projects. A significant flattening in the yield curve, as that would indicate that investors ultimately expect existing Fed rate hike projections to prove recessionary. A rise in 5-year, 5-year forward US Treasury yields above 2.5%, as that would indicate that investors may be upwardly shifting their expectations for the neutral rate of interest. Over the shorter-term, our discussion also underscored that the Omicron variant will likely disrupt economic activity to some degree over the coming three months, and that the risks of a stagflation-lite scenario next year have modestly increased because of the likely maintenance of China’s zero-tolerance COVID policy. We continue to expect that the widespread rollout of booster doses, as well as the progressive availability of effective and safe antiviral drugs, will limit Omicron’s impact on economic activity to the first half of 2022, and that the pandemic will recede in importance next year on average in comparison to 2021. As noted above, this assessment will be monitored continually in response to the release of new information, and we will provide an update in our February report. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst December 23, 2021 Next Report: January 27, 2022 II. Stock Buybacks – Much Ado About Nothing Dear Client, This month’s Special Report is a guest piece by Doug Peta, BCA Research’s Chief US Investment Strategist. Doug’s report examines the impact of US stock buybacks using a median bottom-up approach, and presents a different perspective of the value vs. growth distribution of buybacks than we did in our October Section 2. I trust you will find his report interesting and insightful. Jonathan LaBerge, CFA The Bank Credit Analyst Elected officials’ antipathy for buybacks is unfounded, … : For the companies that are the primary drivers of buyback activity, returning cash to shareholders is more likely to have a positive impact on employment and investment than retaining it.  and the idea that they boost stock returns may be, as well, … : Over the last ten years, a cap-weighted bucket of large-cap stocks that most reduced their share counts underperformed the bucket that most increased their share counts by 2% annually.  especially within the Tech sector, which has most enthusiastically executed them: Despite the success of Apple, which has seen its market cap soar since embarking on a deliberate strategy to shrink its shares outstanding, a strategy buying Tech’s biggest net reducers and selling its biggest net issuers would have generated sizable negative alpha over the last ten years. The problem is the relative profile of net buyers and net issuers: In general, companies that consistently buy back their own stock are mature companies that cannot earn an accretive return by redeploying the capital their incumbent business generates. Net issuers, on the other hand, are often young companies seeking fresh capital to realize their abundant growth opportunities. The next year is likely to see a pickup of share buybacks nonetheless, … : Our US Equity Strategy service’s Cash Yield Prediction Model points to increased buyback activity in 2022. … as management teams are wedded to them and buying back stock is the best use of capital for the mature companies executing them: Better to return cash to shareholders than to enter new business lines beyond the company’s area of expertise or embark on dubious acquisitions, even in the face of a potential 1% surtax. In Capitol Hill’s current polarized state, stock buybacks are in select company with the tech giants and China as issues that unite solons on both sides of the aisle. They are also a hot-button issue for some investors, who see them as telltale signs of a market kept aloft by sleight of hand. Although we do not think they’re worth getting worked up over – they do not promote the misallocation of capital and they may not actually boost stock prices – they come up repeatedly in client discussions and are likely to remain a feature of the landscape even if they are eventually subjected to a modest federal surtax. We have therefore joined with the BCA Equity Analyzer team to pore over its bottom-up database for insights into the buyback phenomenon. After ranking nearly 600 stocks in our large-cap universe in order of their rolling 12-month percentage change in shares outstanding across the last ten years, we were surprised to discover that the companies that most reduced their share count underperformed the companies that most grew it. We were also surprised to find that Tech was by far the worst performer among the six sectors with negative net issuance. Ultimately, the performance story seemed to boil down to Growth stocks’ extended recent edge over Value stocks. We present the data, our interpretation of it, and some future investment implications in this Special Report. Buybacks’ Bad Rap From Capitol Hill to the White House, prominent Washington voices bemoan buybacks. In a February 2019 New York Times opinion piece,5 Senators Sanders (I-VT) and Schumer (D-NY) argued that equity buybacks divert resources from productive investment in the narrow interest of boosting share prices for the benefit of shareholders and corporate executives. To counter the increasing popularity of buybacks, they proposed legislation that would permit buybacks only after several preconditions for investing in workers and communities had been met. Echoing their concerns, the White House's framework for the Build Back Better bill included a 1% surcharge on stock buybacks, “which corporate executives too often use to enrich themselves rather than investing in workers and growing the economy.” Chart II-1The Smallest Companies Sell Stock; The Largest Buy It Back Buybacks’ opponents may mean well, but they seem to be missing an essential point: by and large, the companies that buy back their own stock lack enough attractive investment opportunities to absorb the cash their operations generate. Companies with more opportunities than cash don’t buy back stock; they issue it (and/or borrow) to get the capital to pursue them. The simple generalization that large, mature companies buy back shares while small, growing companies issue new ones is borne out by rolling 12-month percentage changes in shares outstanding by large-cap and small-cap companies (Chart II-1). On an equal-weighted basis, large-cap companies’ rolling share count was flat to modestly down for ten years before the pandemic drove net issuance. Adjusting for market cap, rolling net issuance has been uninterruptedly negative, shrinking by more than 2% per year, on average. The equally weighted small-cap population has been a net issuer to the tune of about 4% annually, with the biggest small-caps issuing even more, pushing the cap-weighted annual average to north of 6%. The bottom line is that large-cap companies in the aggregate have been modestly trimming their share counts, with the biggest companies retiring more than 2% of their shares each year, while small-cap companies are serial issuers, led by their largest (and presumably most bankable) constituents. We are investors serving investors, not policymakers, academics or editorial columnists charged with developing and evaluating public policy. Our mandate is bullish or bearish, not good or bad. We point out the flaws in the prevailing criticism of buybacks simply to make the point that buybacks are not an impediment to productive investment and that no one should therefore expect that productivity and income will rise if legislators or regulators restrict them. On the contrary, since we believe that buybacks represent an efficient allocation of capital, we would expect that successful attempts to limit them will hold back growth at the margin. The Buyback Calculus A company that buys back more of its shares than it issues reduces its share count. All else equal, a company with fewer shares outstanding will report greater earnings per share and a higher return on equity. Increased earnings per share (EPS) does not necessarily ensure a higher share price; if a company’s P/E multiple declines by more than EPS rises, its price will fall. Distributing retained earnings to shareholders reduces a company’s capital buffer against shocks and limits its ability to fund investment internally, but companies that embark on the most ambitious buyback campaigns likely face limited investment opportunities and have much more of a buffer than they could conceivably require. Revealed preferences suggest that management teams like buybacks. They have every interest in getting share prices higher to maximize the value of their own compensation, which typically contains an equity component that accounts for an increasing share of total compensation the more they rise in the company’s hierarchy. It is unclear, however, just how much their attachment to buybacks is founded on an expectation that buying back stock will boost its price. The opportunity to extend their tenure by pursuing a shareholder-friendly policy may well offer a stronger incentive. Do Buybacks Boost Share Prices? Returning cash to shareholders is widely perceived as good corporate governance. It increases the effective near-term yield on an equity investment and denies management the cash to pursue dubious expansion schemes or squander capital on lavish perquisites. It facilitates the reallocation of capital away from cash cows to more productive uses. Buybacks are squarely beneficial in theory, but are they good for investors in practice? (Please see the Box II-1 for a description of the methodology we followed to answer the empirical question.) Box II-1 Performance Calculation Methodology After separating stocks into large- and small-cap categories based on Standard & Poor’s market cap parameters for inclusion in the S&P 500 and the SmallCap 600 indexes, we ranked the constituents in each category in reverse order of their rolling 12-month percentage change in shares outstanding at the end of each month from 2011 through 2021. We then placed the top three deciles (the biggest reducers of their share counts) into the High Buybacks bucket and the bottom three deciles (the biggest net issuers) into the Low Buybacks bucket. We used the buckets to backtest a zero-net-exposure strategy of buying the stocks in the High bucket with the proceeds from shorting the stocks in the Low bucket, calling it the High-Minus-Low (“HML”) strategy. We computed two sets of HML results for the large-cap and small-cap universes. The first populated the buckets without regard for sector representation (“sector-agnostic”) and the second populated the buckets in line with the sector composition of the S&P 500 and SmallCap 600 Indexes (“sector-neutral”). We also track equal-weighted and cap-weighted versions of each HML bucket to gain a sense of performance differences between constituents by size. The experience of the last ten years fails to support the widely held view that stock buybacks boost share prices. Following a zero-net-exposure strategy of owning the top three deciles of large-cap companies ranked by the rolling 12-month percentage reduction of shares outstanding and shorting the bottom three deciles generated a modest positive annual return above 1% (Chart II-2). Small caps merely broke even, largely because their biggest share reducers sharply underperformed in Year 1 of the pandemic. On a cap-weighted basis, however, the large-cap strategy generated a negative annual return a little over 1% during the period, indicating that the largest companies pursuing buyback programs lagged their net issuer counterparts. For small caps, the cap-weighted strategy also lagged the equal-weighted strategy, albeit by a smaller margin. On a sector-neutral basis, the large-cap HML strategy roundly disappointed. The equal-weighted version was never able to do much more than break even, slipping into the red when COVID arrived, while the cap-weighted version continuously lagged it, shedding about 1.5% annually (Chart II-3). Though it was hit hard by the pandemic, the equal-weighted small-cap HML strategy managed to generate about 1% annually, and boasted a 3.5% annualized return for the eight years through 2019. Chart II-2Buybacks May Help A Company's Stock Price At The Margin ... Chart II-3... But They Are Not An Exploitable Factor   Drilling down to the sector level offers some additional insights. While changes in shares outstanding vary across large-cap sectors, with six sectors reducing their shares outstanding and five expanding them, every small-cap sector has been a net issuer in every single year, ex-Discretionaries and Industrials in 2019 (Chart II-4). Relative sector capital needs are largely consistent regardless of market cap, however, with REITs, which distribute all their income to preserve their tax-free status, unable to expand without raising cash in the capital markets, and Utilities, Energy and traditional Telecom Services being capital-intensive industries (Table II-1). Many Tech niches are capital-light, and established Industrials and Consumer businesses often throw off cash. There is less large- and small-cap commonality in HML relative sector performance than in relative sector issuance. Away from Real Estate, Tech and Discretionaries, small-cap HML sector strategies generated aggregate positive returns, led by Communication Services and Energy (Chart II-5). For the large caps, most HML sector strategies produced negative alpha, though the four winners and the one modest loser (Financials) are among the six sectors that have net retired shares outstanding since 2012. Tech is the conspicuous exception, with its HML strategy yielding annualized losses exceeding 3%, contrasting with the sector’s enthusiastic buyback embrace. The Corporate Life Cycle Surprising as they may be on their face, negative cap-weighted ten-year HML returns do not mean that buybacks are counterproductive. We simply think they illustrate that net issuance activity follows from a company’s position in the corporate life cycle (Figure II-1). Investors have prized growth in the aftermath of the global financial crisis, and the companies with the best growth prospects are often younger companies just beginning to tap their addressable markets. They have a long pathway of market share capture ahead of them and need to raise capital to begin traveling it. Many of these strong growers populate the Low basket, especially in the Tech sector. Companies that return cash to their owners via share repurchases are often more mature. Their operations are comfortably profitable and generate more than enough cash to sustain them. They have already captured all the market share they’re likely to gain in their primary business and may not have an outlet for its proceeds in a space in which they have a plausible competitive advantage. Lacking a clear path to bettering the returns from their main operations, they have been steadily accumulating cash for a long time. Through the lens of the Boston Consulting Group’s (BCG) growth share matrix,6 a successful business in the Maturity stage of the business life cycle is known as a Cash Cow. Cash Cows have gained considerable market share in their industry, affording them a competitive advantage based on scale, brand and experience, but little scope for growth because they have saturated a market that is itself mature (Figure II-2). BCG advises management teams with a portfolio of business lines to milk Cash Cows for capital to reinvest in high-share, high-growth-potential Stars or low-share, high-growth-potential Question Marks that could be developed into Stars. In the public markets, a mature large-cap company that retains its excess capital impedes its owners’ ability to redeploy that capital to faster growing investments, subverting the overall economy’s ability to redirect capital to its best uses. Walmart, Twentieth-Century Growth Darling Chart II-6From Young Turk To Respected Elder Walmart fits the business life cycle framework to a T and has evolved into a textbook Cash Cow. It is a dominant player that executed its initial strategy so well that it has maxed out its share in the declining/stagnating brick-and-mortar retail industry. Its international attempts to replicate its domestic success have uniformly failed to gain traction, and it currently operates in fewer major countries than it's exited. Given Walmart’s star-crossed international experience and the dismal history of large corporate combinations, returning cash may be the optimal use of shareholder capital. Walmart began life as a public company in fiscal 1971 squarely in the Growth phase. It was profitable from the start and grew annual revenues by at least 25% for every one of its first 23 years of public ownership (Chart II-6, top panel). It was a modest issuer of shares during its Growth phase, conducting just one secondary common stock offering 12 years after its IPO and otherwise limiting growth in shares outstanding to acquisitions, management incentive awards and debt and preferred stock conversions. Once its revenue growth slipped into the low double-digits in the late nineties, it began retiring its shares at a deliberate pace (Table II-2). That retirement inaugurated a ramping up of Walmart’s annual payout ratio (Chart II-6, bottom panel) and cash yield (dividend yield plus buyback yield), underlining its transition from Growth to Maturity. Walmart’s 2010 admission into the S&P 500 Pure Value Index marked its ripening into full maturity, and it has been a Pure Value fixture since 2013. Today’s stolid icon is a far cry from the ambitious disruptor on display in its 1980 Annual Report: Subsequent to year end, your Company’s directors authorized [a one-third] increase in the annual dividend[.] This continues your Company’s approach of distributing a portion of profits to our shareholders and utilizing the balance to fund our aggressive expansion program. [T]he decade of the ’70’s … has been a tremendous growth period for your Company. In January 1970, we … had 32 stores …, comprising less than a million square feet of retail space. In the next ten years, we added 258 … stores, … constructed and opened three new distribution facilities, and increased our retail space to 12.6 million square feet. During that same period of time, we increased our sales and earnings at an annual compounded rate well in excess of 40 percent. Reflecting upon the progress we have made in the ‘70’s makes it apparent that there is even more opportunity in the ‘80’s for your Company, and we are better positioned to maximize our opportunities … than ever before. The Exception That Proves The Rule Apple has shined so far in the twenty-first century much like Walmart did in the latter stages of the twentieth, growing its revenues and net income at compound annual rates exceeding 20% and 25%, respectively. Unlike Walmart, however, Apple hasn’t required a steady stream of capital to grow. While Walmart had to plow its earnings right back into the business to fund the acquisition and buildout of property to create stores, warehouses and distribution centers, Apple has simply had to make incremental improvements to its music players, phones and tablets while shoring up the moats around its virtual app and music marketplaces. As a result, cash and retained earnings began silting up on Apple’s balance sheet, lying fallow in short-term marketable securities and crimping a range of return metrics. Beginning in its 2013 fiscal year, Apple embarked on a lengthy strategy of returning that cash to shareholders, buying back stock at a rate that has allowed it to reduce its shares outstanding by 37.5% in the space of nine years (Table II-3). It has reduced its retained earnings by more than $90 billion over that span and is on course to wipe them out completely in the fiscal year ending next September. Equity issuance in the form of incentive compensation augments Apple’s capital by about $5 billion per year, but if it continues to distribute more than 100% of its annual earnings in the form of dividends and repurchases, it could wipe out the rest of its recorded equity capital as well. Does this mean Apple is in danger of sliding into insolvency? Not in the least. The value of its assets dramatically exceeds the value of its liabilities, as evidenced by its nearly $3 trillion market cap and the top AAA credit rating Moody’s awarded it this week. Its reported book value is artificially suppressed by generally accepted accounting principles’ inability to value organically developed intellectual property (IP). Apple’s book value and that of other companies that generate similar IP, or benefit from internally generated moats, are dramatically undervalued. Takeaways For now, Apple is an anomaly when it comes to aggressively returning cash to shareholders while it is still in the Growth stage of its life cycle. Returning cash is typically the province of mature companies with steady operations that are unlikely to grow. It is generally good for the economy when those companies return excess cash to shareholders, freeing it up for more productive uses. If lawmakers or regulators manage to restrict the flow of capital from cash-cow companies to potential stars, we should expect activity to slow at the margin, not quicken. The experience of the last ten years suggests that companies that shrink their share counts do not outperform their counterparts that expand them. The trading strategy of shorting the biggest net share issuers to purchase the biggest net share reducers has produced negative returns. It is unclear if shareholders of companies who cannot redeploy their internally generated capital to augment the returns from their primary operations would be better served if their manager-agents retained the capital, though we suspect they would not. It seems inevitable that manager-agents with access to too much capital will eventually get into mischief. If buying back stock represents good corporate stewardship at mature companies, their shareholders should someday be rewarded for it. Given that the companies most suited to buying back stock tend to fit in the Value style box, the zero-net-exposure HML strategy may continue to accrue losses. Apple remains an outlier among Growth companies as an avid buyer of its stock; much more common are the S&P 500 Life and Multi-Line Insurer sub-industry groups, without which the S&P 500 Pure Value Index would have a hard time reaching a quorum (Table II-4). Their constituents have assiduously bought back their stock over the last ten years, albeit to no relative avail (Chart II-7). However, they should be better positioned once Value returns to favor and rising interest rates make investing their cash flow a more attractive proposition. Chart II-7... But No One Else Seems To Want To   Doug Peta, CFA Chief US Investment Strategist III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to move in a tighter direction over the coming year, which is in line with the Fed’s recent hawkish shift. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises are rolling over, but there is no meaningful sign of waning forward earnings momentum. Bottom-up analyst earning expectations remain too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury Yield remains well below the fair value implied by a mid-2022 rate hike scenario, underscoring that a move higher over the coming year is quite likely. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, could weigh on commodity prices at some point over the coming 6 months. We expect stronger metals prices in the back half of 2022. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "OUTLOOK 2022: Peak Inflation – Or Just Getting Started?", dated December 1, 2021, available at bca.bcaresearch.com 2   Early assessment of the clinical severity of the SARS-CoV-2 Omicron variant in South Africa by Wolter et al., medRxiv preprint, December 21, 2021. 3  Please see The Bank Credit Analyst “The Return To Maximum Employment: It May Be Faster Than You Think”, dated August 26, 2021, available at bca.bcaresearch.com 4  Please see US Bond Strategy “The Fed In 2022”, dated December 21, 2021, available at bca.bcaresearch.com 5   Opinion | Schumer and Sanders: Limit Corporate Stock Buybacks - The New York Times (nytimes.com) Accessed December 17, 2021. 6   https://www.bcg.com/about/overview/our-history/growth-share-matrix Accessed December 19, 2021. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Special Report

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 11th with our Portfolio Allocation Summary for January 2022. Highlights Interest Rate Policy: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. The Flexible Average Inflation Target: The re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. It is likely here to stay. The Long-Run Neutral Rate: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed. A Year Of Tightening The Fed started 2021 with three conditions for lifting rates (Table 1). Now, as we head into 2022, the Fed has officially acknowledged that the two conditions related to inflation have been met, and Fed Chair Jay Powell said that the economy is making “rapid progress” toward the final condition of “maximum employment”. Table 1The Fed's Liftoff Criteria Based on this, it looks like rate hikes are imminent. The Fed recently doubled its pace of asset purchase tapering so that net purchases will reach zero by mid-March. This opens up the March 2022 FOMC meeting as the first “live meeting” where a rate hike could occur. Our base case expectation is that the Fed will wait a tad longer, but that liftoff will occur at the June FOMC meeting. Rate hikes will then proceed through the end of the year at a pace of 25 basis points per quarter. Next, we discuss why the Fed has adopted this hawkish posture. We also consider the factors that would cause tightening to proceed more quickly or more slowly in 2022. Reasons For The Fed’s Hawkish Pivot Chart 1Labor Market Indicators It might sound odd to say that the US economy is rapidly approaching maximum employment. After all, the labor market is still 3.9 million jobs short of where it was in February 2020 (Chart 1). What’s more, only 59.2% of the population is employed today compared to 61.1% prior to the pandemic (Chart 1, panel 2). But Fed Chair Powell wasn’t referring to either of those figures when he said that the economy is making “rapid progress” toward maximum employment. Rather, he was referring to the unemployment rate, which currently sits at 4.2% (Chart 1, panel 3). This is only 0.2% above the Fed’s estimate of the natural rate of unemployment and only 0.7% above the pre-pandemic level of 3.5%. The fact that the unemployment rate has declined sharply means that the bulk of the shortfall in the economy-wide number of jobs is the result of people dropping out of the labor force (Chart 1, bottom panel), not the result of an increase in the percentage of the labor force that is unemployed. As recently as the November FOMC meeting, the Fed wasn’t drawing a sharp distinction between these two trends. In fact, Chair Powell said in his post-meeting press conference that “there is still ground to cover to reach maximum employment, both in terms of employment and in terms of participation.” But just one month later, at the December FOMC press conference, Chair Powell struck a much different tone. He said: Chart 2Participation Trends The Demographic Downtrend In Participation But the reality is, we don’t have a strong labor force participation recovery yet and we may not have it for some time. At the same time, we have to make policy now. And inflation is well above target. So this is something we need to take into account. It appears that the Fed is no longer confident that labor force participation is about to rise. There are a few good reasons for this. First, the aging of the US population imparts a structural demographic downtrend to the labor force participation rate as an increasing number of people reach retirement age (Chart 2). In addition, there was a sharp drop in 55+ participation at the onset of the pandemic that has so far not recovered at all (Chart 2, panel 2). It is debatable whether people in this older age cohort will ever return to work. Finally, there is a shortfall in participation for people in their prime working years (ages 25-54) (Chart 2, bottom panel). These people are likely not working because of factors related to the pandemic (e.g. fear of getting sick, caregiving requirements). It is likely that prime-age participation will rise as pandemic concerns fade, but the Fed is no longer confident that these pandemic concerns will fade quickly. Faced with elevated inflation right now, the Fed has decided that it must act against inflation earlier than it had intended, before prime-age labor force participation makes a full recovery. For bond investors, the important takeaway from the recent shift in Fed policy is that a recovery in labor force participation is no longer a pre-condition for liftoff. That being the case, we are very close to the Fed pulling the trigger on rate hikes. Table 2 shows the average monthly nonfarm payroll growth required to reach different target unemployment rates by different future dates, assuming the labor force participation rate remains at its current level. With the participation rate held flat, it only takes average monthly nonfarm payroll growth of 224 thousand to reach the pre-COVID unemployment rate of 3.5% by June. That same rate of growth would cause the unemployment rate to fall below the Fed’s 4% natural rate estimate by January. Table 2Average Monthly Nonfarm Payroll Growth (Thousands) Required To Reach Unemployment Rate Target By Given Date The message is clear. With rising participation no longer a pre-condition for hikes, the Fed’s “maximum employment” liftoff condition will be met within the next few months. We expect this will lead to the first Fed rate hike at the June 2022 FOMC meeting. What Happened To “Transitory” Inflation? Chart 3Core CPI Components The Fed’s view of the labor force participation rate is very similar to its view of inflation. Both are being influenced by the pandemic, but the Fed is no longer confident that pandemic concerns will fade in a timely manner. Looking at the inflation picture, it’s easy to see the impact of the pandemic. Core goods inflation is running at a year-over-year rate of 9.4%. It was close to 0% prior to COVID (Chart 3). This is obviously the result of pandemic-related supply chain disruptions and the shift in consumer spending away from services and toward goods. Just like with labor force participation, these trends should reverse as pandemic concerns fade. However, given the pandemic’s uncertain duration, the Fed is no longer willing to wait for that to happen. The Fed’s Interest Rate Projections In line with its hawkish shift on the definition of “maximum employment”, FOMC participants revised up their interest rate projections at the December meeting. The median FOMC participant is now looking for three 25 basis point rate hikes in 2022. This is consistent with liftoff in June followed by a pace of one rate hike per quarter (Chart 4). Interestingly, the market is reasonably well priced for this near-term path for rates. The deviation between market pricing and Fed expectations occurs further out the curve. As such, we recommend that US bond investors keep portfolio duration low and favor the 2-year Treasury note over the 10-year.1 Chart 4Rate Expectations What Would Make The Fed Go Faster? Chart 5No Wage/Price Spiral Yet As noted above, our base case forecast is that the Fed will start lifting rates in June 2022 and continue to hike at a pace of 25 bps per quarter. This is roughly consistent with the Fed’s own median projections. However, we acknowledge that the Fed will tighten policy more quickly if it sees evidence of an emerging wage-price spiral. Specifically, the Fed has pointed to the risk that real wage growth might exceed the rate of productivity growth. If that were to occur, the Fed would be worried about a wage-price spiral where firms lift prices to meet wage demands, but that only causes employee inflation expectations to rise further, leading to even greater wage demands. So far, this is not occurring. Real wage growth is negative and long-dated inflation expectations remain well-anchored near the Fed’s target levels (Chart 5). An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations during the next few months would cause the Fed to bring forward the liftoff date and increase the pace of rate hikes in 2022. What Would Make The Fed Go Slower? The main thing that would cause the Fed to tighten more slowly in 2022 would be if its hawkish shift prompted a severe tightening in overall financial conditions. Chart 6 shows that the ends of Fed tightening cycles typically coincide with the Goldman Sachs Financial Conditions Index moving above 100. This tightening in financial conditions also typically precedes a slowdown in economic growth (Chart 6, panel 2). Chart 6Watch Financial Conditions And Treasury Slope As The Fed Tightens Financial conditions are incredibly easy at present. But it is conceivable that risky assets will sell-off on fears of Fed rate hikes, and a large enough sell-off would cause the Fed to pause. The slope of the Treasury curve could also be a useful indicator in this regard. The 2/10 slope is usually close to inversion when the Fed ends its rate hike cycles (Chart 6, panel 3). Bottom Line: The Fed will tighten policy in 2022. Our baseline expectation is that the first hike will occur in June 2022 and that rate increases will proceed at a pace of 25 basis points per quarter through the end of the year. An increase in real wage growth to above the rate of productivity growth and/or a break-out in long-dated inflation expectations would cause the Fed to tighten more quickly. An abrupt tightening of financial conditions would cause the Fed to move more slowly. US bond investors should position for this outcome by keeping portfolio duration low and by favoring the 2-year Treasury note over the 10-year. FAIT Accompli It’s been roughly one year since the Fed concluded its Strategic Review and released a revised Statement on Longer-Run Goals and Monetary Policy Strategy.2 One year on, it seems appropriate to consider how much Fed policy actually changed as a result. We focus on what, in our view, are the two most significant changes to the Fed’s Statement. 1.  No More Pre-Mature Tightening First, the Fed changed its strategy to focus on “shortfalls of employment from its maximum level” rather than “deviations from its maximum level”. In the Fed’s words, “this change signals that high employment, in the absence of unwanted increases in inflation […], will not by itself be a cause for policy concern.” In the past, the Fed would tighten policy in response to a low unemployment rate on the expectation that inflation was about to increase. The new strategy is to wait for inflation to emerge before tightening, even if the unemployment rate is very low. Inflation has obviously emerged, so policy tightening is justified even under the new framework. Nonetheless, the evidence shows that the Fed has waited longer than usual to tighten. Chart 7A shows the change in the unemployment rate since the previous trough for the current cycle alongside the previous three cycles. For prior cycles, the lines end when the Fed delivers its first rate hike. While it’s notable that the unemployment rate has improved much more quickly this time around, it’s just as notable that the Fed still hasn’t lifted rates. This is despite the fact that the unemployment rate is only 0.7% above its pre-recession trough. This is more progress than was made before tightening in the 1990 and 2000 cycles, and about the same amount of progress as was made in the 107 months since the unemployment rate troughed before the Great Financial Crisis. A broader measure of labor market utilization, the prime-age (25-54) employment-to-population ratio, tells a similar story (Chart 7B). By this metric, the labor market has already made more progress than it did during the prior two cycles and the Fed still hasn’t increased the funds rate. All in all, even though inflation has emerged earlier this cycle than most expected, it’s pretty clear that the Fed’s new focus on employment “shortfalls” instead of “deviations” has made it act more dovishly. 2. Flexible Average Inflation Targeting (FAIT) The second big change that the Fed made to its Statement on Longer-Run Goals and Monetary Policy Strategy was the introduction of a Flexible Average Inflation Target (FAIT). Under the FAIT framework, the Fed will no longer view its 2% inflation target as purely forward looking. Rather, the Fed will seek to achieve average 2% inflation over time. This means that, “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” While the Fed doesn’t specify a period over which it seeks 2% average inflation, it seems clear that the new inflation target has been achieved. PCE inflation is well above where it would have been if it averaged 2% since the new framework was adopted in August 2020 (Chart 8). This is also true if we pick February 2020, the peak of the last cycle, as our starting point. In fact, PCE inflation has almost made up for the entire inflation shortfall since January 2010. Chart 8The FAIT Framework While it’s interesting to look at average inflation over different lookback periods, it’s more important to note that the actual goal of the FAIT framework is to keep long-dated inflation expectations anchored near target levels. In the Fed’s own words: By seeking inflation that averages 2 percent over time this will help ensure that longer-run inflation expectations do not drift down and remain well anchored at 2 percent.3 If we judge the effectiveness of FAIT based on trends in long-term inflation expectations, then the only reasonable conclusion is that it has been a massive success. By any measure, long-term inflation expectations were well below levels consistent with the Fed’s 2% target in fall 2020. Now, they are very close to target levels. This is true whether we look at market-based measures (Chart 9A), survey measures (Chart 9B), trend measures (Chart 9C) or a composite indicator of many different measures (Chart 9D). Chart 9AMarket-Based Inflation Expectations Chart 9BSurvey-Based Inflation Expectations Chart 9CTrend Measures Of Inflation ##br##Expectations Chart 9DThe CIE Index The Fed's New Index Of Common Inflation Expectations (CIE) The Verdict All told, it looks like the Fed has made good on its promises. It refrained from lifting rates as the unemployment rate fell and has only now moved toward tightening in response to extremely high inflation. Also, the re-anchoring of long-term inflation expectations suggests that the Fed’s new FAIT framework is viewed as credible and is working as intended. Neutral Rate Expectations In 2022 Chart 10Neutral Rate Estimates There is one key issue for both Fed policy and bond markets that we have not yet discussed, and that’s the long-run neutral fed funds rate. This is the interest rate that, on average, will be consistent with the Fed’s price stability and maximum employment goals in the long run. As of today, the consensus among central bankers and investors is that the neutral rate is very low compared to history. There is also a widespread belief that it will remain low for the foreseeable future. For example, here is a sentence from the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy: The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. The top panel of Chart 10 shows that the Fed has revised its median estimate of the long-run neutral rate substantially lower since 2012, down from 4.3% to 2.5%. And it’s not just the Fed that has done so. The same downward revisions are seen in the Surveys of Market Participants and Primary Dealers (Chart 10, bottom 2 panels). Incidentally, the 5-year/5-year forward Treasury yield – a market-derived proxy for the long-run neutral rate – is below even the survey estimates. This is a key reason for our below-benchmark portfolio duration stance. Why Does The Fed Believe That The Neutral Rate Is Low And Will Stay Low? Chart 11The Demographic Effect New York Fed President John Williams has cited three key reasons for the low neutral fed funds rate: demographics, lower productivity growth and a heightened demand for safe and liquid assets.4 Of those factors, Fed research has determined that demographics are particularly important. The trend of increasing life expectancy, specifically, has been shown to be an important factor pushing interest rates down as people increase their savings in anticipation of a longer retirement (Chart 11).5 Could The Fed Be Wrong? We aren’t as confident that the neutral rate will stay low. In fact, we think it’s possible that both Fed and investor estimates understate the current long-run neutral rate. Our own Bank Credit Analyst has observed that the 5-year/5-year forward Treasury yield was very close to trend nominal GDP growth up until the 2008 financial crisis (Chart 12). Then, it dipped below as a protracted period of household deleveraging caused private sector credit demand to dry up. With household balance sheets no longer in disrepair, we are starting to see an increase in household debt, one that could eventually push bond yields back toward trend growth.6 It’s not just our own research that is starting to question the popular narrative of a low neutral fed funds rate. At the most recent Jackson Hole summit, Atif Mian, Ludwig Straub and Amir Sufi presented a paper that shows that rising income inequality is predominantly responsible for today’s low neutral rate (Chart 13), not the demographic effect previously identified by the Fed.7 Chart 13Rising Income Inequality ##br##Since 1980 Chart 12Household Deleveraging Kept Rates Low Post-2008 This research has important implications for the future evolution of the neutral rate. Unlike demographics, income inequality can be altered by changes in tax policy and by shifts in the power struggle between capital owners and workers. In this regard, our US Investment Strategy service has written several reports demonstrating the ongoing structural shift toward greater labor power.8 If this structural trend continues, it suggests that the long-run neutral rate may also rise. Trading The Neutral Rate While we suspect that the long-run neutral fed funds rate will turn out to be higher than both the market and Fed anticipate, we don’t think it’s wise to trade on that view in 2022. The reason is that expectations of a low neutral fed funds rate are extremely well-entrenched. It will take a lot of contrary evidence to shift those expectations, evidence we probably won’t get next year. As noted above, survey estimates of the long-run neutral rate range roughly from 2.0% to 2.5%. Our sense is that those estimates will only be revised higher if the fed funds rate gets much closer to those levels, say at least above 1%, and the economic data suggest that further rate increases will be required. This is a story for 2023, not 2022. A recent paper documented some interesting facts about the relationship between monetary policy and market expectations.9  It observed that the entire decline in the 10-year Treasury yield since 1990 has occurred during 3-day windows around FOMC meetings (Chart 14). This is not what we would expect to see if the long-run neutral rate was determined by independent macroeconomic factors that are distinct from Fed interest rate decisions. Chart 14Fed Rate Decisions Drive Long-Maturity Bond Yields We find this research very compelling. It suggests that the market changes its neutral rate expectations in response to Fed interest rate moves. In our view, this strengthens our conviction that a series of rate hikes will eventually cause the market to push its neutral rate expectations higher, leading to a sell-off in long-maturity bonds. Bottom Line: We think it’s likely that consensus estimates of a 2.0% to 2.5% long-run neutral fed funds rate will turn out to be too low, but we don’t recommend trading on that view in 2022. The low neutral rate narrative is very well-entrenched, and it will only be questioned after several rate hikes have been delivered and their economic impact is assessed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For our full set of recommendations please see US Bond Strategy Special Report, “Key Views 2022: US Fixed Income”, dated December 14, 2021. 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-qas.htm#7 4 https://www.newyorkfed.org/newsevents/speeches/2018/wil181130#footnote3 5 https://www.frbsf.org/economic-research/files/el2017-27.pdf 6 For more details on this argument please see Bank Credit Analyst Special Report, “R-star, And The Structural Risk To Stocks”, dated March 31, 2021. 7 https://www.kansascityfed.org/documents/8337/JH_paper_Sufi_3.pdf 8 Please see January 13, January 20 and February 3, 2020 US Investment Strategy Special Reports, “An Investor’s Guide To US Labor History”, “Where Strikes Come From And Who Wins Them” and “The Public-Approval Contest”. 9 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3550593 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Clients, This is the final publication for the year, in which we recap some of the key economic developments this month. Our publishing schedule will resume on January 6, 2022. The China Investment Strategy team wishes you a very happy and safe holiday season and a prosperous New Year! Best regards, Jing Sima China Strategist   Feature Recently released data show China’s economy is weakening despite easing monetary policy and power-supply constraints. Our credit impulse – measured by the year-on-year change in total social financing as a share of GDP – inched up in November (Chart 1, top panel).  Given that the indicator leads economic activity by about six to nine months, we maintain the view that China’s economy will not bottom until Q2 next year. Chinese stocks, driven by business cycle, will remain under downward pressures in the next three to six months (Chart 1, middle and bottom panels). On the policy front, the PBoC announced a 50bps cut in the reserve requirement ratio (RRR) rate taking effect in mid-December. Last week’s Central Economic Work Conference (CEWC) signaled that stabilizing the economy will be the government’s core policy objective for 2022. However, we believe that policymakers will be data dependent and will only allow an overshoot in credit growth when the slowdown in the economy gathers pace in early 2022. Thus, investors should maintain an underweight allocation to Chinese equities relative to global stocks, at least for the next three to six months, until credit growth significantly improves.   Chart 1Downside Risks Remain High For Chinese Stocks Until The Econmomy Troughs Chart 2Chinese Internet Stocks Are Not Cheap Chinese investable stocks, particularly internet companies, will continue to face geopolitical and regulatory headwinds in the next 12 months. Chinese tech stocks sold off this year, but they are not cheap (Chart 2). Economic weakness in the onshore market in the next three to six months may trigger more selloffs and further multiples compressions in Chinese investable stocks.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Cuts To The RRR And Relending Rates: Not Game Changers Chart 3RRR Cut Is Not A Game Changer Following the RRR cut announcement in early December, the PBoC announced a 25bps decrease in the relending rate targeting agriculture and small businesses (Chart 3). The measures sent an easing signal in response to mounting downside risks in the economy. However, their impact on credit growth will likely be limited for the following reasons: First, the PBoC indicated that the RRR cut will release around RMB1.2 trillion in liquidity to the banks. From that amount, RMB950 billion will be used to replace maturing Medium-term Lending Facility (MLF) this month, which leaves only RMB250 billion for new liquidity injection. Chart 4Business Conditions For SMEs Deteriorated Faster Than For Larger Businesses Secondly, the PBoC is trying to prevent a jump in market-based rates in the next two quarters.  Demand for liquidity is usually high due to tax season by year-end plus a front-loading of local government bond (LGB) issuance. Moreover, the Chinese New Year in Q1 2022 will further boost demand for liquidity. Thirdly, the targeted relending rate drop is intended to lower the borrowing costs of small-medium enterprises (SMEs) whose profitability has been challenged by rising input costs and sluggish consumer demand (Chart 4). Loan demand from small enterprises, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their larger peers (Chart 4, bottom panel). The rate cut has decreased the possibility of a broadly based decline in interest rates in the near-term. China’s Credit Growth May Have Bottomed, But The Rebound Is Moderate  Chart 5Below-Expectation Credit Growth In November China’s aggregate credit growth ticked up slightly in November. The modest advance mainly reflects an acceleration in LGB issuance. Chart 5 highlights that excluding LGB financing, China’s credit impulse remains on a downward trend. LGBs will be frontloaded in Q1 2022 before the March National People’s Congress sets the full-year quota for LGBs.  However, without a meaningful rebound in bank loan growth, the effects of LGB issuance on infrastructure investment will be limited and short-lived, as occurred in Q1 2019 (Chart 6). Shadow banking, which historically has had a tight correlation with infrastructure investment, continued to slide in November to an all-time low. Infrastructure project approval also does not show any signs of strengthening (Chart 7). Chart 6Improvement In Infrastructure Investment Will Be Limited Without An Acceleration In Loan Growth Chart 7Key Indicators Show Weak Signs Of Revival In Infrastructure Spending Weak demand for bank loans from corporations dragged down credit growth in November as evidenced by softening growth in medium- and long-term corporate loans (Chart 8). Both corporate financing needs and investment willingness continued to wane, implying that corporate demand for bank lending may not turn around soon despite recent monetary easing (Chart 8, bottom panel). In addition, marginal easing measures in the property market have not worked their way into the sector. Bank loans to real estate developers plummeted to all-time lows last month, while trust loans contracted significantly in November, which indicates that financing conditions for real estate developers have not improved (Chart 9). Chart 8Loan Demand Remains Weak And Unlikely To Turn Around Imminently Chart 9Deepening Contraction In Trust Loans Indicates Deteriorating Financing Conditions For Real Estate Developers Easing Of Property Restrictions Will Marginally Benefit The Housing Market Last week’s Politburo meeting and the CEWC both proposed to promote affordable rental housing and support reasonable housing demand. Loan growth to government-subsidized social welfare housing has been decelerating since 2018 and started to contract this year (Chart 10). It will likely strengthen next year amid policy support, but from a very low level and at a modest rate. In addition, although social welfare housing loans account for around 40% of bank loans to real estate developers, they are only about 6% of developers’ total source of funding as of 2020. We expect more policy finetuning in the coming months, which may help slow the pace of deterioration in real estate developers’ financing conditions. Real estate developers’ financing from banks may bottom on the back of government’s intervention, but the improvement in total funds to developers will be gradual without mortgage rate cuts and a pickup in home sales (Chart 11). Meanwhile, the downward trend in housing completion will be sustained in the coming months (Chart 11, top panel). Chart 10Bank Loans To Social Welfare Housing Will Likely Improve Modestly Amid Policy Support Chart 11Less Funding = Reduced Completions And Investments Housing prices in most Tier-one and Tier-two cities continued to move down through November. Data for high-frequency floor space sold show that housing demand continued to abate last month despite a modest uptick in household mortgage loans (Chart 12). Home sales will remain depressed as buyers expect more discounts in housing prices and real estate tax reforms loom. Falling prices and constraints in developers’ financing will continue to weigh on housing starts, given the strong positive correlation between property starts and housing prices (Chart 13). Chart 12Demand For Housing In November Showed Little Signs Of Revival Chart 13Housing Starts Are Highly Correlated With Prices   The Rebound In November’s PMI Does Not Signal A Bottom In China’s Economy Chart 14China's PMI Rebounds Amid Supply-Side Improvement The NBS manufacturing PMI returned to above the 50-expansionary threshold in November, but the rise reflects a near-term supply-side improvement related to the power shortage rather than a demand-driven recovery (Chart 14). China’s overall business conditions and domestic demand are still worsening, indicating that the rebound in the manufacturing PMI may be short-lived. The production subindex jumped by three and half percentage points in November from October, reflecting re-started operation of heavy-industry enterprises that were halted amid electricity shortages in September and October. Robust global demand for China’s manufactured goods supported a strong reading in November’s new export orders subindex. However, domestic demand remains lackluster. A proxy for the new domestic orders derived from the PMI reached its lowest level since February 2020 (Chart 14, bottom panel). In addition, service PMI weakened last month. A sharp resurgence in domestic COVID cases curbed service sector activity last month. Given uncertainties surrounding the Omicron variant and China’s zero-tolerance policy towards COVID, the service sector’s recovery will likely remain below-trend into 1H 2022 (Chart 15 and 16). Chart 15Lingering COVID Effects Will Continue To Impede Service Sector Activity In 1H22 Chart 16Service Sector Recovery In China Has Lagged Inflation Passthroughs Ongoing Producer price index (PPI) inflation may have peaked. Meanwhile, the consumer price index (CPI) shows another upturn in November. Despite the peak in PPI inflation, it will likely remain above trend through at least 1H22, supported by elevated commodity and energy prices (Chart 17). Chart 17PPI May Have Peaked, But Will Remain Elevated In The Near Term Chart 18Ongoing Inflation Passthroughs A synchronized rise between PPI consumer goods and non-food CPI, and a narrower gap between PPI and CPI inflation, suggest an ongoing inflation passthrough from producers to consumers (Chart 18). Price increases in some key sectors of manufactured consumer goods sped up in November (Chart 19). However, we do not think China’s consumer price inflation will prevent policymakers from further policy easing. Consumer goods prices are lightly weighted in China’s CPI. An acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates. Headline CPI may gather steam next year if food prices rise while energy prices remain at current levels. Nonetheless, in recent years China’s monetary policymaking has been more tightly correlated with the PPI and core CPI, and not headline CPI (Chart 20). Chart 19Manufactured Consumer Goods Prices On The Rise Chart 20Monetary Policy Is Tightly Correlated With Core CPI And Not Headline CPI Surging Prices Underpin China’s Exports, While The Rebound In Imports Is Unsustainable Chart 21Surging Export Prices Underpinned Strong Growth In The Value Of China's Exports Chinese exports in volume tumbled in November, however, surging export prices underpinned the strong growth in the value of exports (Chart 21). Demand from the US drove Chinese exports this year and the moderation in volume growth was more than offset by escalating prices (Chart 22). China’s export prices have caught up with the global average (Chart 23). Chart 22Strong Demand From US Has Driven Up China's Exports Chart 23Chinese Export Prices Have Caught Up With The Global Average We expect China’s export growth to slow in the new year on the back of softer global growth and a rotation in US household consumption from goods to services  (Chart 24). However, while slowing, global economic growth is projected to remain above trend. The low level of industrial inventories will also provide support to the demand for goods, which will help to sustain strong growth in Chinese exports (Chart 25). China’s imports surprised to the upside in November, boosted by imports of commodities such as coal and crude oil. November’s acceleration in imports reflects a higher demand for primary commodities from Chinese producers, who recovered some production capacity from the power shortages in the previous few months. Chart 24US Household Spending Will Shift From Goods To Services Chart 25Inventory Restocking In The US Will Support Chinese Exports Next Year Furthermore, the increase in import prices in November outpaced the very modest uptick in the volume of imports, indicating that domestic demand remains sluggish (Chart 26). Credit growth, which normally leads import growth by about six months, only climbed moderately in November and will provide limited support to imports in the coming months (Chart 27). Chart 26Rising Import Prices Masked Weakness In China's Domestic Demand Chart 27Modest Rebound In Credit Impulse Will Provide Little Support To Chinese Imports Chart 28Chinese Demand For Industrial Metals Remains In Deep Contraction China’s imports of industrial metals, such as copper and steel, improved a little in November, but their year-on-year growth remains in deep contraction (Chart 28). Weakening construction activity amid a continued downtrend in China’s property market will likely reduce the demand for industrial metals. Therefore, the rebound in November’s import growth may be short-lived. The RMB Faces Headwinds In 2022 Regardless Of A Rise In FX Deposit RRR The RMB has climbed about 2% against the dollar since late July despite broad-based dollar strength. In trade-weighted terms, the RMB is at its strongest level since late 2015 (Chart 29). A rapidly appreciating RMB does not bode well for China’s industrial sector profits, and thus not at the PBoC’s best interests (Chart 30). Under this backdrop, last week the PBoC announced that it will raise the banks’ foreign exchange (FX) deposit reserve requirement ratio (RRR) to 9% from 7%, effective December 15. This is the second increase this year aimed at easing the RMB’s pace of appreciation. The RMB fell slightly against the US dollar following the announcement last week. Chart 29The RMB Has Strengthened Despite A Strong USD Chart 30Strengthening RMB Does Not Bode Well For Corporate Profit Growth The RMB appreciation against dollar this year was mainly enhanced by China’s record current account surplus and favorable interest rate differentials between China and the US (Chart 31 and 32). Although the increase in the deposit RRR rate will force banks to hold more foreign currencies and lift the cost of RMB speculation, the RRR hike itself has little impact on altering the existing path in RMB exchange rate. Moreover, the balance of FX deposits stands at US$1 trillion as of November this year. The 200bps increase in the FX deposit reserve ratio will only freeze about US$20 billion in FX liquidity, which is negligible compared with the US$580 billion in China’s trade surplus so far this year. Chart 31Current Account Surplus Will Likely Shrink Next Year Chart 32Interest Rate Differentials Will Narrow Further However, looking forward the conditions favored RMB this year are at risk of reversing in 2022. China’s weaker economic fundamentals and a slower pace in trade surplus next year, as well as narrowed interest rate differentials between the US and China due to falling long-duration bond yields in China, will provide headwinds to RMB. Therefore, investors should closely follow these key factors and to be cautious to bet on continued RMB appreciation. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Market/Sector Recommendations Cyclical Investment Stance

Special Report

Highlights Below-Benchmark Portfolio Duration: Bond investors should keep portfolio duration low in 2022. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Own Treasury Curve Steepeners: The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Sell Short-Maturity TIPS: Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. We also recommend an outright short position in 2-year TIPS, as short-maturity real yields have a lot of upside in 2022. Overweight Corporate Bonds Versus Treasuries … For Now: We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. Overweight Emerging Market Bonds Versus US Corporates: EM bonds offer an attractive spread advantage versus US corporates, and a weakening US dollar will help boost returns in 2022. A Maximum Overweight Allocation To Municipal Bonds: Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. Underweight Agency MBS: Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. Feature BCA published its 2022 Outlook on December 1st. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer seven key US fixed income views for 2022. This report is limited to the seven key investment views, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2022” report that will delve into our outlook for the Fed next year. Outlook Summary First, a summary of the main economic views presented in BCA’s 2022 Outlook.1   On Economic Growth: The COVID-19 pandemic will recede in importance in 2022 allowing US economic growth to remain above trend. Sizeable household savings and wealth will support consumer spending, the composition of which will shift away from goods and towards services. Corporate capital expenditures also look set to surge. On Inflation: A transition in consumer spending from goods to services and an increase in labor supply will cause US inflation to fall in 2022, though it will remain above the Fed’s target. On Fed Policy: The first Fed rate hike will occur between June and December 2022, depending on the paths of inflation and inflation expectations during the next few months. Fed tightening will continue into 2023. On China and Emerging Markets: Further policy easing in H1 2022 will lead to a reacceleration in Chinese economic activity in the back half of the year. The BCA house view is negative on EM equities for now but will turn more bullish when clearer signs of Chinese policy easing emerge. Risks To The Outlook: The greatest risk to the outlook is that the spread of the Omicron variant leads to the re-imposition of public health measures that will weigh on economic activity. The effect of the Omicron variant remains uncertain, but increasingly widespread vaccination and the advent of anti-viral treatments should help mitigate any negative economic impacts. Key View #1: Below-Benchmark Portfolio Duration Bond investors should keep portfolio duration low in 2022, favoring the 2-year maturity over the 10-year. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Our recommendation to keep portfolio duration low in 2022 stems directly from our assessment of Federal Reserve policy. Without going into too much detail – we will do that in next week’s “Fed In 2022” report – the Fed appears to have adopted a more hawkish reaction function during the past month. The Fed’s official forward guidance says that it will not lift rates until the labor market reaches “maximum employment”. However, Fed Chair Jay Powell weakened that commitment in recent Senate testimony. Powell said that persistently high inflation threatens the economic recovery and implied that to reach its maximum employment goal the Fed may need to act pre-emptively to tame inflation. To us, this means that the Fed’s “maximum employment” condition for lifting rates is no longer binding. The Fed will accelerate the pace of tapering when it meets this week and will start lifting rates between June and December of next year, depending on the interim trends in inflation and inflation expectations. After liftoff, Fed rate hikes will proceed at a predictable pace of 75-100 bps per year until economic growth slows significantly. We expect the fed funds rate to reach at least 2% before that occurs, consistent with survey estimates of the long-run neutral fed funds rate. Let’s compare our estimate of the future fed funds rate path with what is currently priced in the bond market (Chart 1). Chart 1The Market's Rate Expectations Liftoff The overnight index swap (OIS) curve is priced for Fed liftoff in May 2022. This is a tad early compared to our projections, but not by much. Pace After liftoff, the OIS curve is priced for the fed funds rate to rise 79 bps during the subsequent 12 months. Again, this is roughly consistent with our own expectations that the Fed will deliver three or four 25 basis point rate hikes per year. Terminal Rate It is the market’s pricing of the endpoint of the next tightening cycle – the terminal fed funds rate – that disagrees significantly with our forecast. The OIS curve is priced for the funds rate to reach 1.5% in 2024 and then stabilize. This is too low. It is too low compared to the last tightening cycle when the fed funds rate reached 2.45% in 2019. It is also too low compared to survey estimates from market participants and primary dealers. The median respondent to the New York Fed’s Survey of Market Participants estimates that the long-run neutral fed funds rate is 2%. The median response to the same question from the Survey of Primary Dealers is 2.25% and the median FOMC participant pegs the long-run neutral rate at 2.5%. Meanwhile, the 5-year/5-year forward Treasury yield – a rough proxy for the long-run neutral interest rate that’s priced in the Treasury market – sits at only 1.73%. Historically, the 5-year/5-year forward yield converges with survey estimates of the long-run neutral rate as the Fed moves toward tightening (Chart 2). This means the 5-year/5-year forward Treasury yield has at least 27-52 bps of upside in 2022. Chart 25y5y Has Room To Rise Treasury Yield Forecasts Chart 3Treasury Yield Forecasts Chart 3 shows the 2-year, 5-year and 10-year Treasury yields along with the expected paths that are discounted in the forward curve for the next 12 months. The shaded regions in each panel represent our fair value estimates of where those yields will trade if the market moves to price-in our expected future path for the fed funds rate. The upper bound of the fair value range represents the most hawkish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in June, that rate hikes proceed at a pace of 100 bps per year and that the fed funds rate levels-off at a terminal rate of 2.08% (8 bps above the lower-end of a 2%-2.25% target range). The lower bound of the fair value range represents the most dovish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in December 2022, that rate hikes proceed at a pace of 75 bps per year and that the fed funds rate levels-of at a terminal rate of 2.08%. Chart 3 shows that the 10-year Treasury yield is well below even the lower-end of our fair value range. The 5-year Treasury yield is a bit too low compared to our target range and the 2-year yield is consistent with our fair value range, though at the very upper-end. The investment conclusions are obvious. Bond investors should keep portfolio duration low in 2022. They should avoid the 10-year maturity and allocate most funds to shorter maturities like the 2-year. It should be noted that we used a conservative 2.08% terminal rate estimate in the scenarios presented in Chart 3. This is at the low-end of most survey estimates. What’s more, the BCA Outlook makes a strong case that those survey estimates will be revised higher once it becomes apparent that interest rates will have to rise to well above 2% to contain inflation. We agree that survey estimates of the long-run fed funds rate are probably too low, but we don’t expect them to be revised higher in 2022. Upward terminal rate revisions are probably a story for 2023 or 2024, sometime after the Fed has delivered a few rate hikes and it becomes apparent that more will be needed to slow an overheating economy. Appendix A at the end of this report translates different fed funds rate scenarios into 12-month expected returns for every Treasury maturity. We show scenarios where the liftoff date varies between June 2022 and December 2022, where the pace of rate hikes varies between 75 bps and 100 bps per year and where the terminal fed funds rate varies between 2.08% and 2.58%. The 10-year Treasury note is projected to deliver negative returns in every scenario we tested. Meanwhile, the 2-year Treasury note is projected to deliver a small positive return in every single scenario. These results support our conclusion from Chart 3. Investors should maintain below-benchmark portfolio duration and favor short maturities over long maturities. Risks To The View The first risk to our bearish view on US Treasuries is a resurgence of the pandemic. The 10-year Treasury yield continues to track the “pandemic trade” in the stock market. That is, the 10-year yield rises when a basket of equities that benefit from economic re-opening outperforms a basket of equities that benefit from lockdowns, and vice-versa (Chart 4). So far, the news about the virulence of the Omicron COVID variant has been encouraging, and our base case scenario assumes a further easing of pandemic concerns over the course of 2022. The second risk to our view is that the Fed moves too aggressively toward rate hikes causing an abrupt tightening of financial conditions that weighs on economic growth and sends long-dated bond yields lower. The shaded region in Chart 5 shows that this exact dynamic played out in 2018. Fed rate hikes started to pressure the dollar higher and weigh on equities. This led to tighter financial conditions and slower economic growth. The impact of tighter financial conditions was not immediately evident in the bond market, but slower growth eventually caused the Fed to back away from rate hikes leading to a late-2018 peak in the 10-year yield. Chart 410yr Tracks The "Pandemic Trade" Chart 5Watch Financial Conditions In 2022 Compared to the 2018 scenario, we see less risk of Fed over-tightening in 2022 mainly because the fed funds rate is starting out at a much lower level. However, it will be important to track financial conditions as the Fed moves toward liftoff. Undue tightening would cause us to reverse our positioning. Key View #2: Own Treasury Curve Steepeners The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. We also recommend buying the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond as an attractive duration-neutral carry trade. The scenarios presented in the prior section show that the 2-year Treasury yield is priced within the bounds of our estimated fair value range while the 10-year Treasury yield looks too low. Logically, it makes sense to position for a steepening of the 2/10 Treasury curve to profit from this divergence. Chart 6 illustrates the implications of the prior section’s fair value estimates for different Treasury slopes. Our fair value range projects that the 2/10 Treasury slope will be between 38 bps and 89 bps in 12 months, above the 37 bps that is currently priced into the forward curve. The forward curve is also priced for too much flattening in the 2/5 Treasury slope, while the 5/10 slope is consistent with the lower end of our fair value range.   The conclusion is that investors should implement 2/10 Treasury curve steepeners in 2022 on the expectation that the 2/10 slope will flatten by less than what is currently discounted in the forward curve. A comparison of the 5-year/5-year forward Treasury yield with a target range based on survey estimates of the long-run neutral fed funds rate also supports the case for 2/10 steepeners. Historically, an increase in the 5-year/5-year forward yield towards its target range corresponds with a steepening of the 2/10 slope (Chart 7). Bear-flattening moves in the 2/10 slope only occur when the 5-year/5-year forward is within its target band, as was the case in 2017/18. Given that the 5-year/5-year forward yield is currently well below its survey-derived target range, there is room for some 2/10 steepening as yields rise. Chart 6Treasury Slope Forecasts Chart 7A Rising 5y5y Will Steepen The Curve One way to position for a steeper 2/10 curve is to go long the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Presently, this trade looks very attractive. The 2/5/10 butterfly spread shows a significant yield advantage in the 5-year bullet over the 2/10 barbell, both in absolute terms and relative to our fair value model (Chart 8). While we view this as a good trade, we don’t think it’s the best way to position for 2/10 steepening. We prefer a position long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. This trade gives you long exposure at the 2-year maturity instead of the 5-year maturity which will boost returns if the 2/5 slope steepens, as we anticipate it will (Chart 6, panel 2). Chart 8Curve Steepeners Are Cheap In addition to our recommended 2/10 steepener, we advise clients to favor the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. While we’d expect some flattening of the 10/30 slope in 2022, this trade should still perform well because of its huge carry advantage. The tables in Appendix A show that the 20-year bond earns a massive 12-month carry (income plus rolldown return) of 3.05% compared to 1.85% for the 10-year note and 1.80% for the 30-year bond. Key View #3: Sell Short-Maturity TIPS Chart 9TIPS Breakevens Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Other attractive positions include: an outright short position in 2-year TIPS, an inflation curve steepener (short 2yr TIPS/long 2yr nominal/long 10yr TIPS/short 10yr nominal), and a TIPS curve flattener (short 2yr TIPS/long 10yr TIPS). As noted at the beginning of this report, we see inflation trending down in 2022. Inflation will remain high enough for the Fed to feel comfortable lifting rates, but it won’t match the elevated readings that are currently discounted in TIPS. Interestingly, long-maturity TIPS breakeven inflation rates are roughly consistent with the Fed’s 2.3%-2.5% target range (Chart 9). The 5-year/5-year forward TIPS breakeven inflation rate is a bit too low, at 2.13%, and the 10-year TIPS breakeven inflation rate is currently 2.47%. With long-dated TIPS breakevens so close to the Fed’s target, we recommend a neutral allocation to long-maturity TIPS versus long-maturity nominal Treasuries heading into 2022. In our view, the mispricing in TIPS lies at the front-end of the curve. The 2-year TIPS breakeven inflation rate has risen to 3.23%, well above the Fed’s 2.3%-2.5% target range. This year’s surge in short-maturity TIPS breakevens has also resulted in a deeply inverted inflation slope (Chart 9, bottom panel). Table 1Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) Short-maturity inflation expectations are highly sensitive to changes in CPI inflation, much more so than long-maturity expectations. In fact, monthly changes in the 2-year CPI swap rate are more than twice as sensitive to headline inflation than are monthly changes in the 10-year CPI swap rate (Table 1). This means that the cost of short-maturity inflation compensation will decline as inflation moderates in 2022. We recommend an underweight allocation to short-maturity TIPS versus short-maturity nominal Treasuries. We also think an outright short position in 2-year TIPS will be highly profitable in 2022. If we assume that the 2-year TIPS breakeven inflation rate falls to the middle of the Fed’s target range during the next 12 months, and additionally that the 2-year nominal Treasury yield converges with our fair value estimate using the scenario of a September Fed liftoff, 100 bps per year hike pace and 2.08% terminal rate, then we calculate that the 2-year TIPS yield will rise from its current -2.56% to -0.98% during the next 12 months (Chart 10). Chart 10A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS Chart 10 also shows that the anticipated rise in the 2-year TIPS yield greatly outpaces the modest expected increase in the 10-year TIPS yield. This means that a position in 2/10 TIPS curve flatteners will turn a profit in 2022 (Chart 10, bottom panel). Key View #4: Overweight Corporate Bonds Versus Treasuries … For Now We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. A key pillar of our corporate bond investment process is to split the economic cycle into three phases based on the slope of the yield curve (Chart 11). Phase 1 of the cycle is defined as the period from the end of the last recession until the 3-year/10-year Treasury slope breaks below 50 bps. Phase 2 of the cycle spans the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Chart 11The Three Phases Of The Economic Cycle Our historical analysis shows that excess corporate bond returns versus duration-matched Treasuries tend to be strongest in Phase 1. They are usually positive, but much lower, in Phase 2 and are often negative in Phase 3 (Table 2). Table 2Corporate Bond Returns Across The Three Phases Of The Cycle We have been firmly in Phase 1 since April 2020 and, as we would expect, excess corporate bond returns have been strong. However, we will not remain in Phase 1 much longer. The 3-year/10-year Treasury slope is currently 50 bps, right on the precipice between Phase 1 and Phase 2. We recommend an overweight allocation to corporate bonds versus Treasuries for now, but we will adopt a more defensive posture toward corporates once we transition into Phase 2. We expect this will happen sometime in the first half of 2022. Why Are We Not In Phase 2 Already? Chart 12Curve Flattening Is Overdone The 3-year/10-year Treasury slope is hovering right around 50 bps. However, as is noted earlier in this report, we think that recent yield curve flattening is overdone and expect it to reverse somewhat in the coming months. Chart 12 shows the 3-year/10-year slope along with an expected fair value range. This range is based on a 100 bps Fed rate hike pace, a 2.08% terminal rate and varying the liftoff date between June 2022 and December 2022. This fair value range only breaks below 50 bps between March and September of next year. Given our yield curve view, we are positioned for one last period of strong corporate bond outperformance during the next few months. But we will turn more defensive once we judge that we have sustainably transitioned into a Phase 2 environment. Why Turn More Defensive In Phase 2? Chart 13IG Corporate Valuations It’s correct to point out that excess corporate bond returns are still generally positive in Phase 2 environments, so ideally, we would remain overweight corporate bonds versus Treasuries throughout Phase 2. This makes sense theoretically, but strategically we think it will be wise to adopt a different approach this cycle. The main reason to err on the side of caution is that corporate bond valuations are extremely stretched. The 12-month breakeven spread for the investment grade corporate bond index is at its 6th percentile since 1995. This means that the investment grade corporate bond index has only been more expensive than today 6% of the time since 1995 (Chart 13). Tight spreads mean that expected returns will be modest, even in a favorable cyclical environment. In other words, we are not sacrificing much expected return by reducing exposure early in the cycle. Given that we can’t predict the start of the next Phase 3 period with exact precision, we think it makes sense to be more defensive this cycle. We will sacrifice some modest expected returns to ensure that we are well positioned for the next period of significant spread widening. Our corporate bond strategy is supported by an empirical study of historical returns. Table 3A shows average 12-month excess returns for the investment grade corporate bond index after certain combinations of the 3/10 Treasury slope and average index option-adjusted spread (OAS) are observed. Table 3B shows 90% confidence intervals for the averages presented in Table 3A. The tables show that a strategy of remaining overweight corporate bonds versus Treasuries after the yield curve transitions into Phase 2 only works when the corporate index OAS is above 100 bps. A transition into Phase 2 portends negative excess corporate bond returns when the OAS is below 100 bps, as it is today. Favor High-Yield Over Investment Grade Chart 14HY Corporate Valuations While investment grade corporate bonds look extremely expensive compared to history, high-yield corporate bonds look somewhat expensive, but much less so. The average High-Yield index OAS is 1 bp below its pre-COVID low, but investors still get a nice spread pickup for moving out of the Baa-rated credit tier and into the Ba-rated tier (Chart 14). Our prior research has shown that high-yield corporates tend to outperform duration-matched Treasuries when the excess index spread after accounting for default losses is above 100 bps.2 If we assume a minimum required excess spread of 100 bps and a 40% recovery rate on defaulted debt, we can calculate that the junk index is priced for a default rate of 3.4% during the next 12 months (Chart 14, bottom panel). All available evidence suggests that the default rate will come in below 3.4% during the next 12 months, leading to positive excess returns for high-yield corporate bonds. The default rate came in at 1.8% for the 12-month period ending in November and it has been dropping like a stone, consistent with the reading from our Default Rate Model (Chart 15). We also recently wrote about the exceptionally good health of corporate balance sheets.3 We expect the default rate will be in the mid-2% range in 2022, below what is priced into the junk index. Chart 15Corporate Defaults Will Stay Low In 2022 Junk’s valuation advantage leads us to recommend that investors maintain a preference for high-yield corporates over investment grade. We will turn more defensive on both investment grade and high-yield corporates once we transition into a Phase 2 environment, but we may still retain our preference for high-yield over investment grade at that time, as long as junk stays relatively cheap. Key View #5: Overweight Emerging Market Bonds Versus US Corporates Investment grade USD-denominated Emerging Market bonds (both sovereigns and corporates) will outperform US corporate bonds with the same credit rating and duration in 2022. EM bonds offer an attractive spread advantage versus US corporates, and 2022 returns will be boosted by a weakening US dollar. We see an opportunity in Emerging Market (EM) bonds for US investors in 2022. Note that we are only referring to investment grade EM bonds denominated in US dollars. We consider both investment grade USD-denominated EM sovereign bonds and investment grade USD-denominated EM corporate & quasi-sovereign bonds. EM Sovereigns Chart 16EM Sovereigns EM sovereigns have modestly outperformed Treasuries so far this year (see Appendix B for a complete breakdown of year-to-date performance for different corporate bond sectors), and yet the sector remains attractively valued in the sense that the average index OAS has still not recovered its pre-COVID low (Chart 16). A look at recent performance trends shows that EM sovereigns outperformed credit rating and duration-matched US corporates in H2 2020 when the sector benefited from a huge yield advantage and a rapidly depreciating US dollar.4 This year, EM sovereigns lagged US corporates as the dollar strengthened. Looking ahead to 2022, we think that the recent bout of dollar strength is close to its end as the bond market has already moved to price-in an extremely hawkish Fed outlook at the front-end of the curve. A flat or depreciating dollar will benefit EM bonds in 2022, as will the yield advantage in EM sovereigns versus credit rating and duration-matched US corporates (Chart 16, panel 4). This yield advantage will only look more attractive as the Treasury curve flattens and the outlook for US corporate spreads deteriorates. At the country level, we see the best EM sovereign opportunities in Mexico, Russia, Chile, UAE, Qatar and Saudi Arabia. The bonds of all these countries outperformed credit rating and duration-matched US corporate bonds during the past 12 months, and they continue to offer a sizeable spread advantage (Chart 17). EM Corporates & Quasi-Sovereigns The investment grade USD-denominated EM Corporate & Quasi-Sovereign index shows a similar relative return pattern to the EM Sovereign index, though overall performance has been better (Chart 18). We see that the index outperformed credit rating and duration-matched US corporates dramatically in H2 2020 when the dollar was under pressure. Relative returns have been more stable this year as the dollar has strengthened. Chart 18EM Corporates & Quasi-Sovereigns EM corporates & quasi-sovereigns should continue to outperform credit rating and duration-matched US corporates in 2022. A weaker dollar will certainly help, but the main driver of outperformance will be the very attractive yield advantage (Chart 18, panel 4). Key View #6: A Maximum Overweight Allocation To Municipal Bonds Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. US bond investors should favor tax-exempt municipal bonds relative to both Treasuries and equivalently-rated corporate bonds. Long-maturity tax-exempt municipal bonds continue to be one the most attractively priced assets in the US fixed income space. As we discussed in a recent report, one big reason for the attractive valuation is that municipal bonds tend to pay premium coupon rates.5 This significantly reduces the duration risk in long-dated munis. The first two columns of Table 4 show the yield ratios and breakeven tax rates between different municipal bond sectors and duration-matched Treasury securities. We see that the breakeven tax rate – the tax rate that equalizes after-tax yields between the two sectors – is a mere 11% for 12-17 year general obligation munis. The breakeven tax rate between 12-17 year revenue munis and duration-matched Treasuries is only 3%, and the longest-maturity munis actually offer a before-tax yield advantage versus Treasuries! Table 4Muni/Treasury And Muni/Credit Yield Ratios Table 4 shows that munis also offer excellent value compared to corporate bonds with the same credit rating and duration, especially at the long-end of the curve. Breakeven tax rates between munis and corporate credit range from 3% to 21% for maturities longer than 12 years. What’s even more impressive about municipal bonds is that their attractive valuations are buttressed by extremely high credit quality. State & local government balance sheets have received a huge boost from federal stimulus during the past two years, and this has sent net state & local government savings (revenues minus expenditures) surging into positive territory (Chart 19). But it’s not just federal stimulus that has aided state & local governments. Even if we exclude transfer payments altogether, we find that the difference between tax receipts and consumption expenditures is rising sharply relative to interest expense (Chart 19, panel 2). Ratings agencies have noticed the improvement in state & local government budgets and ratings upgrades have far outpaced downgrades during the past year (Chart 19, bottom panel). Chart 19State & Local Balance Sheets In Good Shape Key View #7: Underweight Agency MBS Chart 20Poor MBS Performance Will Continue Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. We noted in a recent report that Agency Mortgage-Backed Securities have performed poorly in 2021.6 The main reason for the poor performance is that the compensation for prepayment risk embedded in MBS spreads (aka option cost) started the year at a very low level, but mortgage refinancing activity has been much higher than expected (Chart 20). The conventional 30-year MBS option cost has been rising, but it is still only back to where it was in 2019 (Chart 20, panel 2). This is not sufficiently attractive for us to advocate buying MBS. While rising bond yields will be a tailwind for refi activity in 2022, we still expect the pace of refinancings to be relatively strong because the rapid run-up in home prices has made it extremely enticing for households to tap the equity in their homes through cash-out refis. Within a recommended underweight allocation to MBS, we recommend that investors favor higher coupon securities over lower coupon ones. Higher-coupon MBS carry less duration than lower-coupon MBS and also wider OAS and greater convexity. This means that high-coupon MBS will outperform low-coupon MBS if bond yields rise in 2022, as we expect they will. Appendix A: Treasury Return Forecasts   Appendix B: US Bond Sector Year-To-Date Performance Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2022: Peak Inflation – Or Just Getting Started?”, dated December 1, 2021. 2 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020. 3 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4 A weaker dollar tends to benefit USD-denominated EM bonds because it makes it easier for foreign issuers to service their dollar denominated debts. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 6 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns