Inflation/Deflation

Highlights Economy – The endpoint of easier-for-longer monetary policy may be coming into view: Elevated inflation readings and discomfort among more hawkish FOMC members may signal that a monetary policy inflection is on the way. Markets – Volatility should pick up as investors reprice financial assets to reflect the end of emergency accommodation: The rumblings in bond, currency and precious metals markets that followed the June FOMC meeting are likely to spread as investors pull their liftoff date expectations forward. Strategy – Maintain below-benchmark duration positioning and ensure that portfolios can withstand increased volatility: Don’t be lulled to sleep by the 10-year Treasury yield’s backing and filling or by the VIX’s foray into the low teens. It is a more auspicious time to be buying insurance than selling it. Feature After fourteen years, investors may be weary of focusing so much attention on the Fed, but there’s been no avoiding its impact since the global financial crisis (GFC) emerged. Zero interest rate policy (ZIRP), large-scale asset purchases and other emergency measures have exerted a strong pull on financial markets as they have been switched on and off. The extended turn of rushing to the rescue appears to be weighing on the Fed as well. Last August’s revisions to its Statement on Longer-Run Goals and Monetary Policy Strategy explicitly acknowledged the challenges of operating in a ZIRP world in which its ability to deploy its primary tool for countering economic weakness – cutting the fed funds rate – is constrained by the zero lower bound. The Fed responded by adjusting its approach to each element of its dual mandate. It adopted an average-inflation-targeting framework that seeks to remediate past inflation shortfalls and indicated that it would only intervene to mitigate shortfalls from its maximum employment estimate. The latter move marked a break with the previous four decades, when the Fed, unwilling to give inflation pressures a chance to take root, proactively tightened policy when it judged that the labor market might be getting too strong. Taken together, the changes amounted to a significant break from doing whatever it took to keep inflation from gaining a foothold to making sure it didn’t completely vanish from households’, businesses’ and investors’ consciousness. If the changes were implemented as outlined, the effects could be wide-ranging. Inflation would be able to gain more traction, all else equal, leading to higher bond yields as markets anticipated that a higher terminal fed funds rate would be required to bring it to heel. A higher terminal fed funds rate might lead to a deeper economic slowdown, ushering in lower bond yields than otherwise would have prevailed. By inducing higher highs and lower lows in Treasury yields, the revisions to the Fed’s framework could promote increased financial market volatility, depending on FOMC members’ ongoing commitment to them and the way that commitment interacted with investors’ expectations. Although the revised framework is eleven months old, it is freshly relevant as the interaction between its implementation and investors’ expectations may be approaching an inflection point. When the FOMC announced the framework revisions last August, it didn’t have any immediate monetary policy implications and investors and committee members could reasonably have figured they would cross the new-framework bridge when they came to it. Elevated inflation readings and some differences in views within the FOMC suggest the bridge might now have to be crossed soon enough to fit within most institutional investors’ time horizons. Volatility may well rise as markets attempt to reprice assets against the backdrop of a novel monetary policy approach. End Of An Era The aforementioned changes that the FOMC made to its monetary policy strategy represented a watershed moment for US monetary policy. Beginning with Paul Volcker’s tenure as Fed chair near the end of the high-inflation ‘70s, the Fed has kept a sharp lookout for inflation pressures (Chart 1). Though it only introduced an annual inflation target in the aftermath of the GFC, its one-way view of inflation was well established. Signs that it might be emerging could be grounds for tighter monetary conditions while dormant readings were nothing to worry about. Chart 1Upholding Volcker's Mantle Upholding Volcker's Mantle Upholding Volcker's Mantle The average inflation target indicates that inflation shortfalls will henceforth be as much of a concern as inflation overshoots and the Fed will attempt to remediate them with an eye towards keeping inflation expectations from slipping below 2%. On the other hand, the new framework shifts from a two-way to a one-way perspective on employment. Where the committee had previously attempted to conduct policy in a way that mitigated any deviations from its maximum-employment assessment, the new framework seeks only to mitigate shortfalls. Citing the post-crisis experience, when inflation remained in check despite a half-century low in the unemployment rate, and a desire to see expansion gains spread more widely across households, Chair Powell has repeatedly emphasized that too much employment is not a concern. Easier Said Than Done When the Fed announced the changes to its approach, we noted that they would be significant for investors provided it were to follow through on them. It is one thing to promise wide-reaching changes in the indefinite future but quite another to execute them in real time under duress. Financial markets seemed to be aware that turning on a dime would be easier said than done and did not bother to adjust their fed funds rate expectations (Chart 2) or reprice assets that might be most affected by the new policy framework. Among investors with a time frame of a year or less, the talk was all theoretical, anyway – of course policy was going to remain extremely easy when the US and the rest of the world were still knee-deep in a once-in-a-century pandemic and the development of an effective vaccine was a ways off. Chart 2Until Recently, Markets Saw Little Chance Of Rate Hikes On A Two-Year Horizon Until Recently, Markets Saw Little Chance Of Rate Hikes On A Two-Year Horizon Until Recently, Markets Saw Little Chance Of Rate Hikes On A Two-Year Horizon In other words, talk was cheap when the FOMC unveiled its new framework. Its plans would only matter once the pandemic’s grip eased and central banks regained some discretion. The committee’s resolve to adhere to the new framework would only be tested in the face of uncomfortably high inflation prints and/or inflation expectations that threatened to anchor at levels above its target range. Investors wouldn’t bother to reprice financial assets in line with the new framework until they were certain it would apply. Inoculating Against Deflation As it turned out, effective vaccines appeared on the horizon sooner than anticipated. Pfizer and BioNTech announced the enormously encouraging results from their vaccine’s Phase III trials before the New York open on November 9th, and the Moderna vaccine’s similar clinical successes followed shortly thereafter. Vaccine distribution would begin in January, and the long end of the Treasury curve would begin to reprice, nudged along by rising inflation expectations. Agita sparked by March CPI data caused expectations to peak ahead of the April release, and 10-year breakevens briefly edged above the levels consistent with the Fed’s goals (Chart 3, top panel). Chart 3Coloring Within The Lines Coloring Within The Lines Coloring Within The Lines Chart 4Unsustainable Outliers Unsustainable Outliers Unsustainable Outliers We share the view of most mainstream economists that the upside surprises in the March and April inflation prints resulted from transitory reopening factors and do not mark an inflection point. Increases in used car prices will slow once rental car companies rebuild their fleets to match burgeoning demand and new car production can resume at its intended pace, lumber prices will continue to ease as sawmills ramp up operations to capture outsized profits, and the pace of increases in airfares will settle down once staffing bottlenecks can be resolved and more flights can be added to meet resurgent demand (Chart 4). Easier For How Much Longer? Markets’ collective shrug upon the release of the revisions to the Fed’s monetary policy framework reflected the view that they did not amount to a meaningful change over most investors’ time horizons. The second wave of COVID-19 infections had peaked a month before, but at least one other was likely in store as students returned to college campuses, and a vaccine was not yet on the horizon. According to Good Judgment’s professional superforecasters, there was roughly an equal 40% probability that 25 million vaccine doses would be available for distribution in the US between October 1st, 2020 and March 31st, 2021 or between April 1st and September 30th, 2021 (Chart 5). The more optimistic estimate turned out to be right, albeit not quite optimistic enough: nearly 25 million doses were administered by the end of February and nearly 50 million by the March 31/April 1 midpoint of the two periods (Chart 6). Chart 5Vaccine Development And Distribution Wound Up Beating August's Expectations ... Transitioning Away From Auto-Pilot Transitioning Away From Auto-Pilot Chart 6... By A Considerable Margin ... By A Considerable Margin ... By A Considerable Margin The vaccine outlook was relevant because it was hard to envision any incremental tightening of monetary policy while the country was still in the throes of the pandemic. Treasury yields at the longer end of the curve weren’t likely to go anywhere in the absence of increases in the fed funds rate (Chart 7) or increases in inflation or real growth expectations. Just as a still-raging virus was likely to keep the FOMC from hiking rates, it would also put a lid on inflation pressures and economic growth. With economic activity sharply limited by social distancing mandates and individuals’ innate reluctance to risk exposure, it was certain that capacity would continue to surpass aggregate demand. Chart 7Treasury Yields Move With Fed Funds Expectations Treasury Yields Move With Fed Funds Expectations Treasury Yields Move With Fed Funds Expectations To the extent investors thought about the FOMC’s new framework when it was unveiled, they seem to have taken it as confirmation that monetary policy would remain easier for longer, consistent with the theme that has prevailed since the Bernanke Fed led the charge to counter the GFC. Treasury yields were subdued even after the vaccine news broke in November (Chart 8, top panel), and with the interest rate structure remaining quiet, there was no major repricing in other rate-sensitive markets. Gold, which might have been expected to benefit from more accommodative policy, slipped nearly 15%, from the mid-$1,900s to the high $1,600s, between the release of the new framework and its March trough. After retracing half of its post-August decline, it shed a fresh 5% following the FOMC’s June meeting (Chart 8, second panel). Chart 8Growth Prospects, Not Fed Prospects Growth Prospects, Not Fed Prospects Growth Prospects, Not Fed Prospects Commodity currencies had added 10% versus the US dollar before ceding half of those gains in the wake of the June FOMC meeting, but their rally appears to have been driven by the increased global growth expectations that followed the positive vaccine news as they went nowhere in September and October (Chart 8, third panel). Similarly, the DXY Index had taken its post-revision cue from global growth prospects, moving inversely with pandemic news (rising when bad, falling when good), before rallying after the June meeting (Chart 8, bottom panel). The rise in measured inflation has encouraged some committee members to bring forward their anticipated liftoff dates and accelerate their individual dot plots, as disclosed last month. Now that the Fed no longer seems to be of one mind on the easier-for-longer path, investors have begun to reassess the scene. Prices are moving as capital reportedly exits pro-inflation positions and the money markets now call for two-and-a-half rate hikes by mid-2023 (Chart 2). More volatility could be in store amidst a shift in the Fed consensus as markets pull forward or push back their expected liftoff date and the expected pace of hikes speeds up or slows down. Investment Implications With the moves in measured inflation and inflation expectations seeming to have met the FOMC’s first two criteria for hiking rates (Table 1), a return to full employment looms as the final hurdle to liftoff. We reiterate our view that hiring progress is the swing factor that investors should be watching to anticipate the coming shift in monetary policy settings. Net payrolls expanded by 850,000 in June, topping estimates and putting the three-month moving average, 567,000, ahead of the 375-485,000 pace required to return the economy to full employment by the second half of 2022.1 That may sound like an overly ambitious target on its face, but we contend that annualized monthly payroll expansion of 4% for fourteen months or 3.1% for eighteen months is attainable given the magnitude of the pandemic job losses (Chart 9). Table 1A Checklist For Liftoff Transitioning Away From Auto-Pilot Transitioning Away From Auto-Pilot Chart 9A 2H22 Return To Full Employment Is Entirely Possible A 2H22 Return To Full Employment Is Entirely Possible A 2H22 Return To Full Employment Is Entirely Possible Our outlook for sustained net payroll expansion remains near the optimistic end of the expectations continuum, though the money market consensus has lately caught up with our sometime-before-the-end-of-2022 liftoff date view (Chart 10). Given that we expect that the yield curve will steepen as the hiring strength shows itself, we advise maintaining below-benchmark duration in Treasury portfolios. The optimism embedded in our hiring view implies robust growth over the next twelve months and we therefore recommend overweighting spread product within fixed income portfolios via a high-yield overweight, and overweighting equities within multi-asset portfolios. Hot growth will eventually induce the Fed to start pumping the monetary brakes, slowing the economy and investment returns, but the twelve-month outlook remains favorable for risk assets. Chart 10Looking For At Least One Hike By The End Of 2022 Looking For At Least One Hike By The End Of 2022 Looking For At Least One Hike By The End Of 2022 Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com   Footnotes 1 Making the simplifying (and overly conservative) assumption that returning to full employment will require recovering February 2020’s level of nonfarm payrolls, the US is currently short 6.8 million jobs. Regaining those jobs by August 2022 (14 months from now) will require a monthly average of 485,000 net job gains; regaining them by December 2022 (18 months hence) will require a 375,000 monthly average.

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth is peaking but will remain solidly above trend. While the proliferation of the Delta strain is likely to trigger another wave of Covid cases this summer, the economic impact will be far smaller than during past waves. Global Asset Allocation: The risk-reward profile for stocks has deteriorated since the start of the year. Nevertheless, with few signs that the global economy is heading towards another major downturn, investors should maintain a modest equity overweight on a 12-month horizon. Equities: Favor cyclicals, value-oriented, and non-US equities. Emerging markets should spring back to life in the autumn once vaccine supplies increase and Chinese fiscal policy turns more stimulative. Fixed Income: Maintain below average interest-rate duration exposure. The 10-year US Treasury yield will finish the year at 1.9%. Spread product will continue to outperform high quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. EUR/USD will finish the year at 1.25. Commodities: Brent will rise to $79/bbl by end-2021, 9% above current market expectations. While the lagged effects from the slowdown in Chinese credit growth earlier this year will weigh on base metals during the summer months, the long-term outlook for metals is positive. Favor gold over cryptos as an inflation hedge. I. Macroeconomic Outlook Global Vaccination Campaign Kicks Into High Gear Nearly 18 months after the pandemic began, the global economy is on the mend. In its latest round of forecasts released on May 31st, the OECD projects that the global economy will expand by 5.8% this year, up from its March projection of 5.6%. The OECD also bumped up its growth forecast for 2022 from 4% to 4.4%. After a rough start, the vaccination campaign is progressing well in most advanced economies (Chart 1). The US and the UK were the first major developed economies to roll out the vaccines, followed by Canada and the EU. While Japan has lagged behind, the pace of vaccinations has picked up lately. Twenty percent of the Japanese population has now received at least one dose. Developing economies are still struggling to secure enough vaccines. Fortunately, this problem should abate over the next six months. The Global Health Innovation Center at Duke University estimates that pharmaceutical companies are on track to produce more than 10 billion vaccine doses this year (Chart 2). While perhaps not enough to inoculate everyone who wants a jab, it will suffice in providing protection to the most vulnerable members of society – the elderly and those with pre-existing medical conditions. Chart 1The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies Chart 2Vaccine Makers Are On Track To Produce Over 10 Billion Doses In 2021 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal New Variants And Vaccine Hesitancy Are Risks Novel strains of the virus remain a concern. First identified in India, the so-called “Delta variant” is spreading around the world. The number of new cases in the UK, where the Delta variant accounts for over 90% of all new infections, is rising again (Chart 3). The latest outbreak has forced the government to postpone “Freedom Day” from June 21st to July 19th (Chart 4). Chart 3The Number Of New Cases In The UK Is Rising Anew 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 4Dismantling Of Lockdown Measures Occurring At Varying Pace 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal     It is highly likely that the Delta variant will produce another wave of cases in the US this summer. Despite ample availability, one-third of Americans over the age of 18 have yet to receive a single dose of a vaccine. As is the case with most everything in the United States, the question of whether to be inoculated has become politicized. In many Republican-leaning states, more than half the population remains unvaccinated (Chart 5). Chart 5The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Vaccine hesitancy will likely diminish as the evidence of their effectiveness continues to mount. According to analysis by the Associated Press using CDC data, fully vaccinated people accounted for less than 1% of the 18,000 COVID-19 deaths in the US in May. A study out of the UK showed that two doses of the Pfizer-BioNTech vaccine was 96% effective against hospitalization from the Delta variant, while the Oxford-AstraZeneca vaccine was 92% effective. While another wave of the pandemic will curb growth this summer, the economic impact will be far smaller than in the past. At this point, the initial terror of the pandemic has faded. Politically, it will be more difficult to justify lockdowns in countries such as the US where almost everyone who wants a vaccine has already been able to get one. Macro Policy Outlook: Tighter But Not Tight After cranking the fire hose to full blast during the pandemic, policymakers are looking to scale back support. On the fiscal side, governments are slowly starting to rein in budget deficits. The IMF expects the fiscal impulse in advanced economies to average -4% of GDP in 2022, implying an incrementally tighter fiscal stance (Chart 6). Chart 6Budget Deficits Set To Decline, But Remain High By Historic Standards 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Tighter does not necessarily mean tight, however. The IMF sees advanced economies running an average cyclically-adjusted primary budget deficit of 2.6% of GDP between 2022 and 2026, compared to an average deficit of 1.1% of GDP between 2014 and 2019. In the US, Congress is debating an infrastructure bill, a key element of President Biden’s “Build Back Better” agenda. If the bill fails to move out of the Senate, our geopolitical strategists expect Congress to use the reconciliation process to pass most of Biden’s legislative program. This should result in an additional 1.3% of GDP in federal spending per year over the next 8 years, offset only partly by higher taxes. Chart 7EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 8Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud In the euro area, the IMF expects fiscal policy to remain structurally looser by nearly 2% of GDP in the post-pandemic period. After six months of parliamentary debates, all 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 7). Most of the money will be spent on public investment projects with high fiscal multipliers. Japan has a habit of tightening fiscal policy at exactly the wrong moment, with the October 2019 hike in the sales tax from 8% to 10% being no exception. Unlike in other developed economies, both the Japanese manufacturing and services PMI remain stuck in the mud (Chart 8). The odds are rising that Prime Minister Yoshihide Suga will announce a major stimulus package after the Olympic Games and ahead of the general election due by October 22nd. China: Normalization Not Deleveraging Chart 9China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up In China, strong export growth, propelled by the shift in global spending towards manufactured goods during the pandemic, allowed the government to tighten fiscal policy modestly in the first half of the year. Looking out, fiscal policy should turn more stimulative. Local governments used only 16% of their bond issuance allocation between January and May, compared with 59% over the same period last year and 40% in 2019. Proceeds should benefit infrastructure spending, which has been on the weak side in recent years (Chart 9). After a sharp decline, Chinese credit growth should stabilize in the second half of the year. The current pace of credit growth of 11% is near its 2018 lows and is broadly in line with nominal GDP growth (Chart 10). Given that the authorities have stated their desire to stabilize the ratio of credit-to-GDP, they are unlikely to proactively suppress credit growth further. The recent decline in the 3-month SHIBOR, which usually moves in the opposite direction of credit growth, is evidence to this effect (Chart 11). Chart 10Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chart 11China: Easing Off The Brakes? China: Easing Off The Brakes? China: Easing Off The Brakes? Nevertheless, changes in fiscal and credit policy tend to affect the Chinese economy with a lag (Chart 12). Thus, the tightening in fiscal policy and the deceleration in credit growth that occurred early this year could still weigh on economic activity during the summer months. Chart 12China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag Don’t Sweat The Dot Plot Markets interpreted the June FOMC meeting in a hawkish light. Both the 2-year and 5-year yield jumped 10 basis points following the meeting (Table 1). The US dollar, which is quite sensitive to changes in short-term rate expectations, strengthened by nearly 2%. In contrast, long-term bond yields declined following the meeting, with the 10-year and 30-year bond yield falling by 6 and 19 basis points, respectively. Table 1Change In Yields Following June FOMC Meeting 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal As long duration assets, stocks take their cues more from long-term yields than short-term rates. Hence, it was not surprising that equities held their ground, and that growth stocks reversed some of their underperformance against value stocks this year. Chart 13Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light This publication agrees with BCA’s bond strategists that the market overreacted to the changes in the Fed’s projections (aka “the dots”). As Chair Powell himself noted during the press conference, the dot plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” The market is currently pricing in 105 basis points of tightening by the end of 2023. Prior to the meeting, investors were expecting 85 basis points in rate hikes (Chart 13). The regional Fed presidents tend to be more hawkish than the Board of Governors. Our guess is that Jay Powell himself only penciled in one hike for 2023. Lael Brainard, who may be replacing Powell next year, likely projects no hikes for 2023. The Path To Full Employment Chart 14The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending Rather than obsessing over the dots, investors should focus on the questions that will actually drive Fed policy, namely how long it takes the US economy to return to full employment and what happens to inflation in the interim and beyond. There is a lot of uncertainty over these questions – both on the demand side (how fast will spending recover?) and the supply side (how much labor market slack is there and how quickly can firms ramp up hiring?). On the demand side, the pandemic led to unprecedented changes in household spending and saving behavior. As Chart 14 shows, goods spending surged while services spending collapsed. Overall spending declined, and together with increased transfer payments, savings ballooned. As of May, US households were sitting on $2.5 trillion in excess savings. Looking at disaggregated bank deposit data as a proxy for the distribution of household savings, the wealthiest 10% of households accounted for about 70% of the increase in savings between Q1 of 2020 and Q1 of 2021 (Chart 15). Given that richer households have relatively low marginal propensities to spend, this suggests that a large fraction of these excess savings will remain unspent. Nevertheless, $2.5 trillion is a lot of money – it’s equal to almost 17% of annual consumption. Hence, even if a third of this cash hoard were to make its way into the economy, it could buoy aggregate demand significantly. Chart 15Excess Savings Have Mostly Flowed To The Rich 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal A Labor Market Puzzle Turning to the supply side, there were over 4% fewer people employed in the US in May than in January 2020 (Chart 16). On the face of it, this would suggest the presence of a significant amount of labor market slack. Chart 16US Employment Still More Than 4% Below Pre-Pandemic Levels 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Yet, the NFIB small business survey tells a different story. It revealed that 48% of firms reported difficulty in filling vacant positions in May, the highest percentage of respondents in the 46-year history of the survey (Chart 17). Chart 17US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 18US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Along the same lines, the nationwide job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The quits rate, a good proxy for worker confidence, is also at a record high (Chart 18). How does one reconcile the low level of employment with other data pointing to a tight labor market? As we discussed in a report two weeks ago, four explanations stand out: Generous unemployment benefits, which have depressed labor force participation among low-wage workers (Chart 19). Chart 19Labor Scarcity Prevalent In Low-Wage Sectors 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 20School Closures Have Curbed Labor Supply 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Pandemic-related school closures. As Chart 20 shows, they have had a noticeable impact on labor force participation among women with young children. Reduced immigration. At one point during the pandemic, visa issuance was down 99% from pre-pandemic levels (Chart 21). An increase in early retirements. We estimate that about 1.5 million more workers retired during the pandemic than would have been expected based solely on demographic trends (Chart 22). Chart 21US Migrant Worker Supply Is Depressed 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 22The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement All but the last effect is likely to be fleeting. Enhanced unemployment benefits expire in September; President Biden has reversed President Trump’s ban on most worker visas; and schools should fully reopen by the fall. And even for the retirement effect, most recent retirees were approaching retirement age anyway. Thus, there will likely be fewer incremental retirements over the next few years. A Speed Limit To Hiring? Assuming that a large fraction of sidelined workers return to the labor market in the fall, how fast will firms be able to hire them? In general, we are skeptical of arguments claiming that there is much of a speed limit to the pace of hiring. Chart 23There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There is a lot of churn in the labor market. Gross job flows are much larger than net flows. Between 2015 and 2019, 66.1 million people were hired on average per year compared with 59.6 million who quit or were discharged. Churn is especially strong in the retail and hospitality sectors, the two segments that account for the bulk of today’s shortfall in jobs. In April of this year, retailers hired nearly 800,000 workers. An additional 1.42 million workers found jobs in the leisure and hospitality sectors. This is equivalent to 5.3% and 10.1% of total employment in those sectors, respectively (Chart 23). And remember, we are talking about only one month’s worth of hiring. During past V-shaped recoveries, employment growth often surpassed 5% on a year-over-year basis (Chart 24). Such a growth rate would produce net 670K new jobs per month, enough to restore full employment by mid-2022. Chart 24V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries The Fed’s Three Criteria For Lift-Off In August of 2020, the Fed formally adopted a “flexible average inflation targeting” framework. It seeks to offset periods of below-target inflation with periods of above-target inflation. The goal is to better anchor long-term inflation expectations, while giving households and firms more clarity over where the price level will be many years out. In the spirit of this new framework, the Fed has made it clear that it needs to see three things before it considers raising rates: The labor market must be at “maximum employment” 12-month PCE inflation must be above 2% The FOMC must expect inflation to remain above 2% for some time If the US economy achieves full employment by the middle of next year, the first criterion will be satisfied. PCE inflation clocked in at 3.9% in May, so at least for now, the second criterion is satisfied as well. The big question concerns the third criterion. How Transitory Is US Inflation Likely To Be? As Chart 25 shows, more than half of the increase in the CPI in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI still remains below its pre-pandemic trend, while the level of the PCE deflator is barely above it (Chart 26). Aside from a few low-wage sectors such as retail and hospitality, overall wage growth remains contained. Neither the Atlanta Fed Wage Growth Tracker nor the Employment Cost Index – the two cleanest measures of US wage inflation – is signaling a brewing wage-price spiral (Chart 27). Chart 25Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 26AUnwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Chart 26BUnwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Chart 27No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now Chart 28Rising Oil Prices Have Fueled The Jump In Inflation Expectations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal   Chart 29Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Chart 30A Top In Inflation Expectations? A Top In Inflation Expectations? A Top In Inflation Expectations? While inflation expectations have risen, they should fall in the second half of the year as gasoline prices descend from their seasonal highs (Chart 28). Market expectations of inflation have already dipped back below the Fed’s comfort zone (Chart 29). Inflation expectations 5-to-10 years out in the University of Michigan’s Survey of Consumers also dropped from 3% in May to 2.8% in June (Chart 30). Overall producer price inflation should decline. Chart 31 shows that lumber prices, steel prices, agriculture prices, and memory chip prices have all peaked. Taken together, all this suggests that the recent surge in inflation is indeed likely to be “transitory.” Chart 31Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over Risk-Management Considerations Favor A “Go Slow” Approach Chart 32Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed The financial press often characterizes the Fed’s monetary policy as ultra-accommodative. With policy rates near zero, one would be forgiven for agreeing. However, the reality is that neither the Fed nor, for that matter, most market participants think that monetary policy is all that easy. Using expectations for the terminal Fed funds rate as a proxy for the neutral rate of interest, the Fed’s estimate of the terminal rate has fallen from 4.3% in 2012 to 2.5% at present (Chart 32). Surveys of primary dealers and other market participants suggest that investors think the terminal rate is even lower than what the Fed believes it to be. It is an open question as to whether the neutral rate really is as low as widely believed. But if it is, raising rates prematurely would be a grave mistake. Given the zero lower bound constraint on nominal policy rates, the Fed would be hard-pressed to ease monetary policy by enough to respond to any future deflationary shock. In contrast, if inflation proves to be more persistent, raising rates to cool the economy would be relatively straightforward. All this suggests that the Fed is likely to maintain its “go slow” approach. This publication expects tapering of QE to begin early next year, with no rate hike until December 2022 or early 2023. Other Central Banks Constrained By The Fed Chart 33Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued The Fed’s dovish bias limits the ability of other developed economy central banks to tighten monetary policy. For some central banks, such as the ECB and BoJ, raising rates is the last thing they want to do. In both the euro area and Japan, long-term inflation expectations remain well below target (Chart 33). The Bank of England is in a better position to tighten monetary policy than the ECB. Inflation expectations are relatively high in the UK and a frothy housing market poses a long-term threat to economic stability. Nevertheless, the need to maintain a competitive currency to facilitate post-Brexit economic adjustments will limit the BoE’s ability to raise rates. Moreover, the departure of BoE Chief Economist, Andy Haldane, from the MPC will silence the sole voice sounding the alarm over rising inflation. Among the G7 economies, the Bank of Canada is the closest to raising rates. After a slow start, the vaccination campaign is now progressing well there. Property prices have gone through the roof. The Western Canada Select oil price has reached the highest level since 2014. The discount to WTI has shrunk from a peak over 50% in November 2018 to about 20% in recent weeks. The Bank of Canada has already begun tapering asset purchases. While concerns about a stronger loonie will tie the BoC’s hands to some extent, the first rate hike is still likely in mid-2022. II. Financial Markets A. Portfolio Strategy The Golden Rule embraced by this publication is “remain bullish on stocks as long as growth is likely to remain strong for the foreseeable future.” Historically, bear markets rarely occur outside of recessions (Chart 34). With both fiscal and monetary policy still supportive, and households in many countries sitting on plenty of dry powder, the odds that the global economy will experience a major downturn in the next 12 months are low. Chart 34Recessions And Bear Markets Tend To Overlap 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal That said, we do acknowledge that the risk-reward profile for equities has deteriorated since the start of the year. Global stocks have risen 12% year-to-date, implying that investors have priced in an increasingly optimistic economic outlook. Our equity valuation indicator points to very poor long-term future returns, particularly in the US (Chart 35). Chart 35ALong-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Chart 35BLong-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Democrats in Congress will likely use the reconciliation process to raise corporate taxes. While this is unlikely to cause major problems for the economy, it could weigh on stocks. As we discussed in a past report, neither analyst earnings estimates nor market expectations are baking in much impact from higher tax rates. Meanwhile, economic growth has peaked in the US and China, and will peak in the other major economies over the balance of 2021. Slower growth is usually associated with lower overall equity returns (Table 2). Stocks are also likely to face headwinds as spending shifts back from goods to services. Goods producers are overrepresented in stock market indices compared to the broader economy. Table 2The Economic Cycle And Financial Assets 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal The fact that global growth is peaking at exceptionally high levels will soften the blow for stocks. Likewise, the need to rebuild inventories and satisfy pent-up demand for some manufactured goods that have been in short supply will keep goods production from falling too drastically. Nevertheless, investors who have been maximally overweight stocks should consider paring exposure by raising cash. Only a modest equity overweight is appropriate going into the second half of this year. B. Equity Sectors, Regions, And Styles While we continue to favor cyclical equity sectors over defensives, non-US over the US, and value over growth, our conviction is lower than it was at the start of the year. In the near term, the lagged effects from the slowdown in Chinese credit growth could weigh on global cyclicals. Cyclicals could also stumble as the Delta variant rolls through the US and other countries. In addition, the US dollar could sustain recent gains as investors continue to fret that the Fed is turning hawkish. A stronger dollar is usually bad for cyclicals and non-US stocks (Chart 36). Chart 36Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 37Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Ultimately, as discussed earlier in this report, the Fed is likely to push back against the market’s hawkish interpretation of its dot plot. The resulting reflationary impulse should cause the dollar to weaken over a 12-month horizon while allowing for a re-steepening of the yield curve. Higher long-term bond yields tend to benefit banks, which are overrepresented in value indices (Chart 37). A stabilization in credit growth and more stimulative Chinese policy later this year should temper concerns about EM growth. Greater access to vaccines will also allow more EM economies to partake in reopening euphoria, thus benefiting local EM stock markets and global cyclicals. C. Fixed Income If stocks are pricey, government bonds are even more dear. Real yields are negative in most G10 economies. And while persistently higher inflation is not an imminent threat, it is a longer-term risk that bond valuations are not discounting. We expect the 10-year US Treasury yield to rise to 1.9% by the end of the year, above current market expectations of 1.61%. As of today, we are expressing this view by going short the 10-year Treasury note in our trade table. US Treasuries have a higher beta than most other government bond markets (Chart 38). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 38US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets BCA’s bond strategists see more upside from high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 2.9%. This is more than their fair-value default estimate of 2.3%-to-2.8% (Chart 39). It is also above the year-to-date realized default rate of 1.8%. Chart 39Spread-Implied Default Rate Spread-Implied Default Rate Spread-Implied Default Rate Our bond team sees USD-denominated EM corporate bonds as being attractively priced relative to domestic investment-grade corporate bonds with the same duration and credit rating. They prefer EM corporates to EM sovereigns in the A and Baa credit tiers, while preferring EM sovereigns over EM corporates in the Aa credit tier. Investors willing to take on foreign-exchange risk should consider EM local-currency bonds. As we discuss next, a weaker US dollar over the next 12 months should translate into stronger EM currencies. D. Currencies Four forces tend to drive the US dollar over cyclical horizons of about 12 months: Growth: As a countercyclical currency, the dollar typically does poorly when global growth is strong. This is especially the case when growth is rotating away from the US to other countries (Chart 40). Bloomberg consensus estimates imply that the US economy will transition from leader to laggard over the coming months, which is dollar bearish (Table 3). Chart 40The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Table 3Growth Is Peaking, But At A Very High Level 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Interest Rate Differentials: The trade-weighted dollar tends to track the real 2-year spread between the US and its trading partners (Chart 41). It is unlikely that US real rates will fall much from current levels. However, the current level of spreads is already consistent with a meaningfully weaker dollar. Chart 41Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Balance Of Payments: The US trade deficit has increased significantly over the past year (Chart 42). Equity inflows have been helping to finance the trade deficit (Chart 43). However, if stronger growth abroad causes equity flows to move out of the US, the dollar will suffer. Chart 42The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly Chart 43Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Momentum: Being a contrarian is a losing strategy when it comes to trading the dollar. This is because the US dollar is a high momentum currency (Chart 44). The dollar usually continues to weaken when it is trading below its various moving averages and sentiment is bearish (Chart 45). At present, while the dollar is near its short-term moving averages, it is still below its long-term moving averages. Sentiment is bearish, but has come off its lows. On balance, the technical picture for the dollar is slightly negative.   Chart 44The Dollar Is A High Momentum Currency 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 45ABeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Chart 45BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Adding it all up, we expect the dollar to weaken over a 12-month horizon. The dollar’s downdraft will likely begin in earnest during the fall when Chinese policy turns more stimulative and fears that the Fed has turned hawkish subside. We expect EUR/USD to finish the year at 1.25. GBP/USD should hit 1.50. Both EM and commodity currencies should also do better. The lone laggard among “fiat currencies” will be the yen. As a highly defensive currency, the yen usually struggles when global growth is firm. Chart 46To This Day, Most Crypto Payments Are Made To Criminals 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal What about cryptocurrencies? I debated the topic with my colleague, Dhaval Joshi, in early June. To make a long story short, I think it is highly unlikely that cryptos will ever thrive. More than 13 years since Bitcoin was created, cryptos continue to be mainly used to facilitate illicit transactions. According to Chainalysis, there were fewer cryptocurrency payments processed by merchants in 2020 than in 2017 (Chart 46). Meanwhile, Bitcoin mining continues to produce significant environmental damage (Chart 47). And if there is any place where there is hyperinflation, it is in the creation of new cryptocurrencies. There are over 5000 cryptocurrencies at last count, double the number at this time last year (Chart 48). We are currently short Bitcoin in our trade table.   Chart 47Bitcoin And Ethereum: How Dare You! 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 48Hyperinflation In New Cryptocurrency Creation 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal E. Commodities Structurally, oil faces a bleak future. Transport accounts for about 60% of global oil consumption. The shift to electric vehicles will undermine this key source of oil demand. Cyclically, however, crude prices could still rise as the global economic recovery unfolds. Supply remains quite tight, reflecting both OPEC vigilance and the steep drop in oil and gas capex of recent years (Chart 49). Bob Ryan, BCA’s chief commodity strategist, expects Brent to rise to $79/bbl by the end of the year, which is 9% above current market expectations (Chart 50). Chart 49Oil And Gas Companies Curtailed Capex In Recent Years 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 50Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Chart 51Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom In contrast to oil, the long-term outlook for base metals is favorable. A typical electric vehicle requires four times as much copper as a typical gasoline-propelled vehicle. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of current annual copper production. Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then (Chart 51). In the near term, however, base metals have to grapple with the lagged effects of slower Chinese credit growth (Chart 52). We downgraded base metals to neutral on May 28 and are currently long global energy stocks via the IXC ETF versus global copper miners via the COPX ETF. We expect to reverse this trade by the fall. We are generally positive on gold. Since peaking last August, the price of gold has fallen more than one might have expected based on movements in real bond yields (Chart 53). Gold will also benefit from a weaker dollar later this year. Lastly, and importantly, gold should retain its standing as a good inflation hedge. Chart 52Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Chart 53Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Special Trade Recommendations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Current MacroQuant Model Scores 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal

Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist   Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year.  Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone.  An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following:  First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend China Outlook: A Mid-Year Recap China Outlook: A Mid-Year Recap Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022.  Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The ongoing transition to a post-pandemic state and fiscal policy are either positive or net-neutral for risky asset prices. Fiscal thrust will turn to fiscal drag over the coming year, but the negative impact this will have on goods spending will likely be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. A modestly hawkish shift in the outlook for monetary policy is likely over the coming year, potentially occurring over the late summer or early fall in response to outsized jobs growth. However, such a shift is not likely to become a negative driver for risky asset prices over the coming 6-12 months, barring a major rise in market expectations for the neutral rate of interest. This may very well occur once the Fed begins to raise interest rates, but not likely before. Investors should overweight risky assets within a multi-asset portfolio, and fixed-income investors should maintain a below-benchmark duration position. We continue to favor value over growth on a 6-12 month time horizon, although growth may outperform in the near term. A bias toward value over the coming year supports an overweight stance toward global ex-US equities, and an overall pro-risk stance favors bearish US dollar bets. Feature Three factors continue to drive our global macroeconomic outlook and our cyclical investment recommendations. The first factor is our assessment of the global progress that is being made on the path to a post-pandemic state, and the return to pre-COVID economic conditions; the second is the likely contribution to growth from fiscal policy over the coming year; and the third is the outlook for monetary policy and whether or not monetary conditions will remain stimulative for both economic activity and financial markets. If the world continues to progress meaningfully on the path to a post-pandemic state, and if the impact of fiscal and monetary policy remains in line with market expectations, then we see no reason to alter our recommended investment stance. Equity market returns will be modest over the coming 6 to 12 months in this scenario given how significantly stocks have rebounded from their low last year, but we would still expect stocks to outperform bonds and would generally be pro-cyclically positioned. We present below our assessment of these three factors and their potential to deviate from consensus expectations over the coming year, to determine their likely impact on economic activity and financial markets. The Ongoing Transition To A Post-Pandemic World Chart I-1Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Chart I-1 highlights that meaningful progress continues to be made in vaccinating the world's population against COVID-19. North America and Europe continue to lead the rest of the world based on the share of people who have received at least one dose, but South America continues to make significant gains, and recent data updates highlight that Asia and Oceania are also making meaningful progress. Africa is the clear laggard in the war against SARS-COV-2 and its variants, but progress there has been delayed, at least in part, by India’s export restrictions of the Oxford-AstraZeneca/COVISHIELD vaccine. This suggests that, while Africa will continue to lag, the share of Africans provided with a first dose of vaccine will begin to rise once India resumes its exports and deliveries to African countries under the COVAX program continue. If variants of the disease were not a source of concern, Chart I-1 would highlight that the full transition to a post-pandemic economy over the next several months would be near certain. However, as evidenced by the recent decision in the UK to postpone the lifting of COVID-19 restrictions by 4 weeks due to the spreading of the Delta variant, the global economy is not entirely out of the woods yet. Encouragingly, the delay in the UK genuinely appears to be temporary. Chart I-2 highlights that while the number of confirmed UK COVID-19 cases has been rising over the past month, the uptick in hospitalizations and fatalities has so far been quite muted. Importantly, the rise in hospitalizations appears to be occurring among those who have not yet been fully vaccinated, underscoring that variants of the disease are only truly concerning if they are vaccine-resistant. The evidence so far is that the Delta variant is more transmissible and may increase the risk of hospitalization, but that two doses of COVID-19 vaccine offer high protection. Of course, vaccines only offer protection if you get them, and evidence of vaccination hesitancy in the US is thus a somewhat worrying sign. Chart I-3 shows that the daily pace of vaccinations in the US has slowed significantly from mid-April levels, resulting in a slower rise in the share of the population that has received at least one dose (second panel). On this metric, the US has recently been outpaced by Canada, and the gap between the UK and the US is now widening. Germany and France are close behind the US and may surpass it soon. Chart I-2The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary Chart I-3Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming   Sadly, Chart I-4 highlights that there is a political dimension to vaccine hesitancy in the US. The chart shows that state by state vaccination rates as a share of the population are strongly predicted by the share of the popular vote for Donald Trump in the 2020 US presidential election. Admittedly, part of this relationship may also be capturing an urban/rural divide, with residents in less-dense rural areas (which typically support Republican presidential candidates) perhaps feeling a lower sense of urgency to become vaccinated against the disease. Chart I-4The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants July 2021 July 2021 But given the clear politicization that has already occurred over some pandemic control measures, such as the wearing of masks, Chart I-4 makes it difficult to avoid the conclusion that the same thing has occurred for vaccines. This is unfortunate, and seemingly raises the risk that the Delta variant may spread widely in red states over the coming several months, potentially delaying economic reopening, or risking the reintroduction of pandemic control measures. However, there are two counterarguments to this concern. First, non-vaccine immunity is probably higher in red than blue states, and CDC data suggest that this effect could be large. While this figure is still preliminary and subject to change (and likely will), the CDC estimates that only 1 out of 4.3 cases of COVID-19 were reported from February 2020 to March 2021. Taken at face value, this implies that there were approximately 115 million infections during that period, compared with under 30 million reported cases. That gap accounts for 25% of the US population, and given that red states were slower to implement pandemic control measures last year and their residents often more resistant to the measures, it stands to reason that a disproportionate share of unreported cases occurred in these states. Second, as noted above, the evidence thus far suggests that the Delta variant is not vaccine resistant, at least for those who are fully vaccinated. This is significant because if Delta were to spread widely in red states over the coming several months, the resulting increase in hospitalizations would likely convince many vaccine hesitant Americans to become vaccinated out of fear and self-interest – two powerfully motivating factors. Thus, the Delta variant may become a problem for the US in the fall, but if that occurs a solution is not far from sight. And, in other developed countries where vaccine hesitancy rates appear to be lower, it would seem that a new, vaccine-resistant variant of the disease would likely be required in order to cause a major disruption in the transition to a post-pandemic state. Such a variant could emerge, but we have seen no evidence thus far that one will before vaccination rates reach levels that would slash the odds of further widespread mutation. Fiscal Policy: Passing The Baton To Services Spending Chart I-5 highlights that US fiscal policy is set to detract from growth over the coming 6-12 months, reflecting the one-off nature of some of the fiscal response to the pandemic. This is true outside of the US as well, as Chart I-6 highlights that the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, representing a significant amount of fiscal drag relative to the past two decades. Chart I-5Fiscal Thrust Will Eventually Turn To Fiscal Drag In The US… July 2021 July 2021 Should investors be concerned about the impact of fiscal drag on advanced economies over the coming year? In our view, the answer is no. The reason is that much of the fiscal response in the US and Europe has been aimed at supporting income that has been lost due to a drastic reduction in services spending, which will continue to recover over the coming months as the effect of the pandemic continues to ebb. Chart I-7 underscores this point by highlighting the “gap” in US consumer goods and services spending relative to its pre-pandemic trend. The chart highlights that US goods spending is running well above what would be expected, whereas there is a sizeable gap in services spending (which accounts for approximately 70% of US personal consumption expenditures). Goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the sizeable amount of excess savings that US households have accumulated over the past year (Chart I-7, panel 2). Chart I-6... And In Europe ... And In Europe ... And In Europe Chart I-7But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services While some of these savings have already been deployed to pay down debt and some may be permanently saved in anticipation of higher future taxes, the key point for investors is that the negative impact on goods spending from reduced fiscal thrust will be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. Monetary Policy: A Modestly Hawkish Shift Is Likely This leaves us with the question of whether or not monetary policy will become a negative driver for risky asset prices over the coming 6-12 months, which is especially relevant following last week’s FOMC meeting. The updated “dot plot” following the meeting shows that 7 of the 18 FOMC participants anticipate a rate hike in 2022, and the majority (13 members) expect at least one rate hike before the end of 2023, raising the median forecast for the Fed funds rate to 0.6% by the end of that year. Chart I-8 highlights that while 10-year Treasury yields remains mostly unchanged following the meeting, yields moved higher at the short-end and middle of the curve. Chart I-8The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields Investor fears that the Fed may shift in a significantly hawkish direction at some point over the next year have been far too focused on inflation, and far too little focused on employment. It is not a coincidence that the Fed’s guidance was updated following the May jobs report, which saw a stronger pace of jobs growth relative to April. Table I-1 updates our US Bond Strategy service’s calculations showing the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 3.5-4.5% assuming a full recovery in the participation rate, which is the range of the Fed’s NAIRU estimates. May’s payroll growth number of 560k implies that the Fed’s maximum employment criterion will be met sometime between June and September next year, if monthly payroll growth continues at that pace. Table I-1Calculating The Distance To Maximum Employment July 2021 July 2021 Chart I-9Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate It is currently difficult to assess with great confidence what average payroll growth will prevail over the coming year, but we noted in last month’s report that there were compelling arguments in favor of outsized jobs growth this fall.1 In addition to those points, we note the following: Blue states have generally been slower to reopen their economies, and Chart I-9 highlights that these states have consequently been slower to return to their pre-pandemic unemployment rate. Among blue states, California and New York are the largest by population, and it is notable that both states only lifted most COVID-19 restrictions on June 15 – including the wearing of masks in most settings. This implies that services jobs are likely to grow significantly in these states over the coming few months. Both consensus private forecasts as well as the Fed’s expectation for real GDP growth imply that the output gap will be closed by Q4 of this year (Chart I-10). These expectations appear to be reasonable, given the substantial amount of excess savings that have been accumulated by US households and the fact that monetary policy remains extremely stimulative. When the output gap turned positive during the last economic cycle, the unemployment rate was approximately 4% – well within the Fed’s NAIRU range. Chart I-10 also shows that the Fed’s 7% real GDP growth forecast for this year would put the output gap above its pre-pandemic level, when the unemployment rate stood at 3.5%. In fact, it is possible that annualized Q2 real GDP growth will disappoint current consensus expectations of 10%, due to the scarcity of labor supply (scarcity that will be eased by labor day when supplemental unemployment insurance benefit programs end). Were Q2 GDP to disappoint due to supply-side limitations, it would strengthen the view that job gains will be very strong this fall ceteris paribus, as it would highlight that real output per worker cannot rise meaningfully further in the short-term and that stronger growth later in the year will necessitate very large job gains. Chart I-11 highlights that US air travel and New York City subway ridership have already returned close to 75% and 50% of their pre-pandemic levels, respectively. Based on the trend over the past three months, the chart implies that air travel will return to its pre-pandemic levels by mid-October of this year, and New York City subway ridership by June 2022. This underscores that travel-related services employment will recover significantly in the fall, and that jobs in downtown cores will rebound as office workers progressively return to work. Chart I-10Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Chart I-11Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall   On the latter point, one major outstanding question affecting the outlook for monetary policy is the magnitude of the likely permanent impact of work from home policies on employment in central business districts. Fewer office workers commuting to downtown office locations suggests that some jobs in the leisure & hospitality, retail trade, professional & business services, and other services industries will never return or will be very slow to do so, arguing for a longer return to maximum employment (and the Fed’s liftoff date). We examine this question in depth in Section 2 of this month’s report, and find that the “stickiness” of work from home policies will likely cause permanent central business job losses on the order of 575k (or 0.35% of the February 2020 labor force). While this would be non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Outsized jobs growth this fall, at a pace that quickly reduces the unemployment rate, argues for a first Fed rate hike that is even earlier than the market expects. Chart I-12 presents The Bank Credit Analyst service’s current assessment of the cumulative odds of the Fed’s liftoff date by quarter; we believe that it is likely that the Fed will have raised rates by Q3 of next year, and that a rate hike in the first half of 2022 is a possibility. These odds are slightly more aggressive than those presented by our fixed-income strategists in a recent Special Report,2 but are consistent with their view that the Fed will raise interest rates by the end of next year. Chart I-12The Bank Credit Analyst’s Assessment Of The Odds Of The First Rate Hike July 2021 July 2021 The odds presented in Chart I-12 are also more hawkish than the Fed funds rate path currently implied by the OIS curve, meaning that we expect investors to be somewhat surprised by a shifting monetary policy outlook at some point over the coming year, potentially over the next 3-6 months. Payroll growth during the late summer and early fall will be a major test for the employment outlook, and is the most likely point for a hawkish shift in the market’s view of monetary policy. Is this likely to become a negative driver for risky asset prices over the coming 6-12 months? In our view, the answer is “probably not.” While investors tend to focus heavily on the timing of the first rate hike as monetary policy begins to tighten, the reality is that it is the least relevant factor driving the fair value of 10-year Treasury yields. Investor expectations for the pace of tightening and especially for the terminal Fed funds rate are far more important, and, while it is quite possible that expectations for the neutral rate of interest will eventually rise, it seems unlikely that this will occur before the Fed actually begins to raise interest rates given that most investors accept the secular stagnation narrative and the view that “R-star” is well below trend rates of growth (we disagree).3 Chart I-13 highlights the fair value path of 10-year Treasury yields until the end of next year, assuming a 2.5% terminal Fed funds rate, no term premium, and a rate hike pace of 1% per year. The chart highlights that while government bond yields are set to move higher over the coming 6-12 months, they are likely to remain between 2-2.5%. This would drop the equity risk premium to a post-2008 low (Chart I-14), which would further reduce the attractiveness of stocks relative to bonds. But we doubt that this would be enough of a decline to cause a selloff, and it would still imply a stimulative level of interest rates for households and firms. Chart I-1310-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply Chart I-14Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP   Investment Conclusions Among the three factors driving our global macroeconomic outlook and our cyclical investment recommendations, continued progress on the path toward a post-pandemic state and fiscal policy remain either positive or mostly neutral for risky assets. A potentially hawkish shift in the outlook for monetary policy this fall remains the chief risk, but we expect the rise in bond yields over the coming year to remain well-contained barring a sea change in investor expectations for the terminal Fed funds rate – which we believe is unlikely to occur before the Fed begins to raise interest rates. Consequently, we continue to recommend that investors should overweight risky assets within a multi-asset portfolio, and that fixed-income investors should maintain a below-benchmark duration position. We expect modest absolute returns from global equities, but even mid-single digit returns are likely to beat those from long-dated government bonds and cash positions. While value stocks may underperform growth stocks over the coming 3-4 months,4 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector (and therefore growth stock) valuations (Chart I-15). Chart I-16 highlights that the attractiveness of US value versus growth is meaningfully less compelling for the S&P 500 Citigroup indexes, suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon.5 Chart I-15Value Is Extremely Cheap Value Is Extremely Cheap Value Is Extremely Cheap Chart I-16Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters   The likely outperformance of value versus growth also has implications for regional allocation within a global equity portfolio. The US is significantly overweight broadly-defined technology relative to global ex-US stocks, and financials – which are overrepresented in value indexes – have already meaningfully outperformed in the US this year compared with their global peers and are now rolling over (Chart I-17). This underscores that investors should favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow (Chart I-18). Chart I-17Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Chart I-18Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets   Finally, global ex-US stocks also tend to outperform when the US dollar is falling, and we would recommend that investors maintain a short dollar position on a 6-12 month time horizon despite the recent bounce in the greenback. Chart I-19 highlights that the dollar remains strongly negatively correlated with global equity returns, and that the dollar’s performance over the past year has been almost exactly in line with what one would have expected given this relationship. Thus, a bullish view toward global stocks implies both US dollar weakness and global ex-US outperformance over the coming year. Chart I-19A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 24, 2021 Next Report: July 29, 2021   II. Work From Home “Stickiness” And The Outlook For Monetary Policy Work from home policies, originally designed as emergency measures in the early phase of the COVID-19 pandemic, are likely to be “sticky” in a post-pandemic world. This will negatively impact the labor market in central business districts, via reduced spending on services by office workers. The potential impact of working from home is often cited as an example of what is likely to be a lasting and negative effect on jobs growth, but we find that it is not likely to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment.” The size of the impact depends importantly on whether employee preferences or employer plans for WFH prevail, but our sense is that the latter is more likely. A weaker pace of structures investment in response to elevated office vacancy rates will likely have an even smaller impact on growth than the effect of reduced central business district services employment. The contribution to growth from structures investment has been small over the past few decades, office building construction is a small portion of overall nonresidential structures, and there are compelling arguments that the net stock of office structures will stay flat, rather than decline. Our analysis suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months. The outlook for US monetary policy over the next 12 to 18 months depends almost entirely on the outlook for employment. Many investors are focused on the potential for elevated inflation to force the Fed to raise interest rates earlier than it currently anticipates, but it is the progress in returning to “maximum employment” that will determine the timing of the first Fed rate hike – and potentially the speed at which interest rates rise once policy begins to tighten. In this report, we estimate the extent to which the “stickiness” of working from home (WFH) policies and practices could leave a lasting negative impact on the US labor market. We noted in last month's report that a large portion of the employment gap relative to pre-pandemic levels can be traced to the leisure & hospitality and professional and business services industries, both of which – along with retail employment – stand to be permanently impaired if the office worker footprint is much lower in a post-COVID world.6 Using employee surveys and a Monte Carlo approach, we present a range of estimates for the permanent impact of WFH policies on the unemployment rate, and separately examine the potential for lower construction of office properties to weigh on growth. We find that the impact of reduced office building construction is likely to be minimal, and that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Relative to the Fed’s expectations of a strong, lasting impact on the labor market from the pandemic, this suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months (a period that may see outperformance of the latter). Quantifying The Labor Market Impact Of The New Normal For Work In a January paper, Barrero, Bloom, and Davis (“BBD”) presented evidence arguing why working from home will “stick.” The authors surveyed 22,500 working-age Americans across several survey “waves” between May and December 2020, and asked about both their preferences and their employer’s plans about working from home after the pandemic. Chart II-1 highlights that the desired amount of paid work from home days (among workers who can work from home) reported by the survey respondents is to approximately 55% of a work week, suggesting that a dramatic reduction in office presence would likely occur if post-pandemic WFH policies were set fully in accordance with worker preferences. Chart II-1Employee Preferences Imply A Dramatic Reduction In Post-COVID Office Presence July 2021 July 2021 However, Table II-1 highlights that employer plans for work from home policies are meaningfully different than those of employees. The table highlights that employers plan for employees to work from home for roughly 22% of paid days post-pandemic, which essentially translates to one day per week on average.7 BBD noted that CEOs and managers have cited the need to support innovation, employee motivation, and company culture as reasons for employees’ physical presence. Managers believe physical interactions are important for these reasons, but employees need only be on premises for about three to four days a week to achieve this. Table II-1 also shows that employers plan to allow higher-income employees more flexibility in terms of working from home, and less flexibility to employees whose earnings are between $20-50k per year. Table II-1Employer Plans, However, Imply Less Working From Home Than Employees Prefer July 2021 July 2021 Based on the survey results, BBD forecast that expenditure in major cities such as Manhattan and San Francisco will fall on the order of 5 to 10%. In order to understand the national labor market impact of work from home policies and what implications this may have on monetary policy, we scale up BBD’s calculations using a Monte Carlo approach that incorporates estimate ranges for several factors: The percent of paid days now working from home for office workers The amount of money spent per week by office workers in central business districts (“CBDs”) The number of total jobs in CBDs The percent of CBD jobs in industries likely to be negatively impacted by reduced office worker expenditure The average weekly earnings of affected CBD workers The average share of business revenue not attributable to strictly variable expenses The percent of affected jobs likely to be recovered outside of CBDs Our approach is as follows. First, we calculate the likely reduction in nationwide CBD spending from reduced office worker presence by multiplying the likely percent of paid days now permanently working from home by the number of total jobs in CBDs and the average weekly spending of office workers. This figure is then increased due to the estimated acceleration in net move outs from principal urban centers in 2020 (Chart II-2); we assume a 5% savings rate and an average annual salary of $50k for these resident workers, and assume that all of their spending occurred within CBDs. We also assume that roughly 50% of jobs connected to this spending are recovered. Chart II-2Fewer Residents Will Also Lower Spending In Central Business Districts July 2021 July 2021 Then, we calculate the gross number of jobs lost in leisure & hospitality, retail trade, and other services by multiplying this estimate of lost spending by an estimate of non-variable costs as a share of revenue for affected industries, and dividing the result by average weekly earnings of affected employees. For affected CBD employees in the administrative and waste services industry, we simply assume that the share of jobs lost matches the percent of paid days now permanently working from home. Finally, we adjust the number of jobs lost by multiplying by 1 minus an assumed “recovery” rate, given that some of the reduction in spending in CBDs will simply be shifted to areas near remote workers’ residences. We assume a slightly lower recovery rate for lost jobs in the administrative and waste services industry. Table II-2 highlights the range of outcomes for each variable used in our simulation, and Charts II-3 and II-4 present the results. The charts highlight that the distribution of outcomes based on employer WFH intensions suggest high odds that nationwide job losses in CBDs due to reduced office worker presence will not exceed 400k. Based on average employee preferences, that number rises to roughly 800-900k. Table II-2The Factors Affecting Permanent Central Business District Job Losses July 2021 July 2021 Chart II-3The Probability Distribution Of CBD Jobs Lost… July 2021 July 2021 Chart II-4…Based On Our Monte Carlo Approach July 2021 July 2021   This raises the question of whether employer plans or employee preferences for WFH arrangements will prevail. Our sense is that it will be closer to the former, given that we noted above that employer WFH plans are the least flexible for employees whose earnings are between $20-50k per year (who are presumably employees who have less ability to influence the policy of firms). Chart II-5 re-presents the projected job losses shown in Chart II-4 as a share of the February 2020 labor force, along with a probability-weighted path that assumes a 75% chance that employer WFH plans will prevail. The chart highlights that WFH arrangements would have the effect of raising the unemployment rate by approximately 0.35%. However, relative to a pre-pandemic starting point of 3.5%, this would raise the unemployment rate to a level that would still be within the Fed’s NAIRU estimates (Chart II-6). Therefore, the “stickiness” of WFH arrangements alone do not seem to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment,” suggesting that the conditions for liftoff may be met earlier than currently anticipated by investors. Chart II-5CBD Job Losses Will Not Be Trivial, But They Will Not Be Enormous July 2021 July 2021 Chart II-6Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment The Impact Of Lower Office Building Construction A permanently reduced office footprint could also conceivably impact the US economy through reduced nonresidential structures investment, as builders of commercial real estate cease to construct new office towers in response to expectations of a long-lasting glut. However, several points highlight that the negative impact on growth from US office tower construction will be even smaller than the CBD employment impact of reduced office worker presence that we noted above. First, Chart II-7 highlights the overall muted impact that nonresidential building investment has had on real GDP growth by removing the contribution to growth from nonresidential structures and for overall nonresidential investment. The chart clearly highlights that the historically positive contribution to real US output from capital expenditures over the past four decades has come from investment in equipment and intellectual property products, not from structures. Chart II-8 echoes this point, by highlighting that US real investment in nonresidential structures has in fact been flat since the early-1980s, contributing positively and negatively to growth only on a cyclical basis (not on a structural basis). Chart II-7Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Chart II-8Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Second, Table II-3 highlights that office properties make up a small portion of investment in private nonresidential structures. In 2019, nominal investment in office structures amounted to $85 billion, compared with $630 billion in overall structures investment, meaning that office properties amounted to just 13% of structures investment. Table II-3Office Structures Investment Is A Small Share Of Total Structures Investment July 2021 July 2021 Table II-4Conceivably, Vacant Office Properties Could Be Converted To Luxury Residential Units July 2021 July 2021 Third, it is true that investment is a flow and not a stock variable, meaning that, if the net stock of office buildings were to fall as a result from WFH policies, then the US economy would see a potentially persistently negative rate of growth from nonresidential structures (which would constitute a drag on growth). But if the net stock were instead to remain flat, then gross office property investment should equal the depreciation of those structures. The second column of Table II-3 highlights that current-cost depreciation of office structures was $53 billion in 2019 (versus nominal gross investment of $85 billion). Had office property investment been ~$30 billion lower in 2019, it would have reduced nominal GDP by a mere 14 basis points (resulting in an annual growth rate of 3.84%, rather than 3.98%). Fourth, there is good reason to believe that the net stock of office properties will stay flat, as the economics of converting offices to luxury housing units (whose demand is not substantially affected by factors such as commuting) – either fully or partially into mixed-use buildings – appear to be plausible. Table II-4 highlights that the average annual asking rent for office space per square foot in Manhattan was $73.23 in Q1 2021, and that the recent median listing home price per square foot is roughly $1,400. In a frictionless world where office space could be instantly and effortlessly sold as residential property, existing prices would imply a healthy (gross) rental yield of 5.2%. Thoughts On The Future Of Office Properties Of course, reality is far from frictionless. There are several barriers that will slow office-to-residential conversion as well as construction costs, which will meaningfully lower the net value of existing office real estate in large central business districts such as Manhattan. In a recent article in the Washington Post, Roger K. Lewis, retired architect and Professor Emeritus of Architecture at the University of Maryland, College Park, detailed several of these technical barriers (which we summarize below).8 Office buildings are typically much wider than residential buildings, the latter usually being 60 to 65 feet in width in order to enable windows and natural light in living/dining rooms and bedrooms. This suggests that office-to-residential conversion might require modifying the basic structure of office buildings, including cutting open parts of roof and floor plates on upper building levels to bring natural light into habitable and interior rooms, and other costly structural modifications to address the additional plumbing and infrastructure that will be needed. Lewis noted that floor-to-floor dimensions are typically larger in office buildings, which is beneficial for office-to-residential conversion because increased room heights augments the sense of space and openness, while allowing natural light to penetrate farther into the apartment. It also allows for extra space to place needed additional building infrastructure, such as sprinkler pipes, electrical conduits, light fixtures, and air ducts. But unique apartment layouts are often needed to use available floor space effectively in an office-to-residential conversion, which will increase design costs and raise the risk that nonstandard layouts may result in unforeseen quality-of-living problems that will necessitate additional future construction to correct. Zoning regulations and building code constraints will likely add another layer of costs to office-to-housing conversions, as these rules are written for conventional buildings, meaning that special exceptions or even regulatory changes are likely to be required. So it is clear that the process of converting office space to residential property will be a costly endeavor for office tower owners, which will likely reduce the net present value of these properties relative to pre-pandemic levels. But; this process appears to be feasible and, when faced with the alternative of persistently high vacancy rates and lost revenue, our sense is that office tower owners will choose this route – thus significantly reducing the likelihood that the growth in national gross investment in office properties will fall below the rate of depreciation. In addition, the trend in suburban and CBD office property prices suggests that there are two other possible alternatives to widespread office-to-residential conversion that would also argue against a significant and long-lasting decline in office structures investment. Chart II-9 highlights that the average asking rent has already fallen significantly in most Manhattan submarkets, and Chart II-10 highlights that suburban office prices are accelerating and rising at the strongest pace relative to CBD office prices over the past two decades, possibly in response to increased demand for workspace that is closer to home for many workers who previously commuted to CBDs. Chart II-9Working From The Office Is Getting Cheaper July 2021 July 2021 Chart II-10Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Thus, the first alternative outcome to CBD office-to-residential conversion is that an increase in suburban office construction offsets the negative impact of outright reductions in CBD office investment if residential conversions prove to be too costly or too technically challenging. The second alternative is that owners of CBD office properties “clear the market” by dramatically cutting rental rates even further, to alter the cost/benefit calculation for firms planning permissive WFH policies. We doubt that existing rents reflect the extent of vacancies in large cities such as Manhattan, so we would expect further CBD office price declines in this scenario. But if owners of centrally-located office properties face significant conversion costs and a decline in the net present value of these buildings is unavoidable and its magnitude uncertain, owners may choose to cut prices drastically as the simpler solution. Investment Conclusions Holding all else equal, the fact that owners of CBD office properties are likely to experience some permanent decline in the value of these real estate assets is not a positive development for economic activity. But these losses will be experienced by firms, investors, and ultra-high net worth individuals with strong marginal propensities to save, suggesting that the economic impact from this shock will be minimal. And as we highlighted above, a decline in the pace of gross office building investment to the depreciation rate will have a minimal impact on the overall economy. This leaves the likely impact on CBD employment as the main channel by which WFH policies are likely to affect monetary policy. As we noted above and as discussed in Section 1 of our report, the Fed is now focused entirely on the return of the labor market to maximum employment, which we interpret as an unemployment rate within the range of the Fed’s NAIRU estimates (3.5% - 4.5%) and a return to a pre-pandemic labor force participation rate. Chart II-11On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth Our analysis indicates that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, this suggests that WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. The implication is that job growth over the coming year could be even stronger than the Fed and investors expect, which could mean that the Fed may begin lifting rates by the middle of next year barring a major disruption in the ongoing transition to a post-pandemic world. This is earlier than we currently expect, but the fact that it would also be earlier than what is currently priced into the OIS curve underscores that fixed-income investors should remain short duration on a 6-12 month time horizon. In addition, as noted in Section 1 of our report, while value stocks may underperform growth stocks over the coming 3-4 months,9 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector valuations. Chart II-11 highlights that the relative valuation of growth stocks remains above its pre-pandemic starting point (Chart II-11), suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon. Finally, as also noted in Section 1 of our report, we do not expect rising bond yields to prevent stock prices from grinding higher over the coming year, unless investor expectations for the terminal fed funds rate move sharply higher – an event that seems unlikely, although not impossible, before monetary policy actually begins to tighten. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst 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 are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields since last August. The indicator still remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have risen to their highest levels on record. Within a global equity portfolio, there has been a modest tick down in global ex-US equity performance, driven by a rally in growth stocks (which may persist for a few months). EM stocks had previously dragged down global ex-US performance, and they continue to languish. A bias towards value stocks on a 1-year time horizon means that investors should still favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow. The US 10-Year Treasury yield has trended modestly lower since mid-March, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and we expect that yields will move higher over the cyclical investment horizon if employment growth in Q3/Q4 implies a faster return to maximum employment than currently projected by the Fed. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a short duration stance within a fixed-income portfolio. The extreme rise in some commodity prices over the past several months is beginning to ease. Lumber prices have fallen close to 50% from their recent high, whereas industrial metals and agricultural prices are down roughly 5% and 17%, respectively. We had previously argued that a breather in commodity prices was likely at some point over the coming several months, and we would expect further declines as supply chains normalize, labor supply recovers, and Chinese demand for metals slows. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). 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 later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report "A Central Bank Timeline For The Next Two Years," dated June 1, 2021, available at usbs.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com 5 For a discussion of the differences in value and growth benchmarks, please see Global Asset Allocation Special Report “Value? Growth? It Really Depends!” dated September 19, 2019, available at gaa.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 7 Readers should note that the desired share of paid work from home days post-COVID among employees is shown to be lower in Table II-1 than what is implied by Chart II-1 on a weighted-average basis. This is due to the fact that Table II-1 excludes responses from the May 2020 survey wave, because the authors did not ask about employer intensions during that wave. This underscores that the average desired number of paid days working from home declined somewhat over time, and thus argues for the value shown in Table II-1 as the best estimate for employee preferences. 8 Roger K. Lewis, “Following pandemic, converting office buildings into housing may become new ‘normal,’ Washington Post, April 3, 2021. 9 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com

Highlights The sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity demand and prices through the remainder of 2021. Commodity demand shocks dominate commodity supply shocks. Commodity supply shocks play only a transient role in setting prices. Go underweight basic resources equities versus the market. Commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar. Fractal trade: Short corn versus wheat. Feature Chart of the WeekDeclining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices The recent collapse in China’s credit impulse has caught a lot of people’s attention, ours included. The collapse in the credit impulse quantifies the change in lending. Importantly, this means that even if the lending numbers themselves are large, the impulse will collapse if those lending numbers are declining – which is precisely what has happened in China. In the past year, China’s broad money supply has expanded by $17 trillion yuan, signifying a large amount of lending in the $100 trillion yuan economy. All well and good, except that the $17 trillion yuan has declined from an even larger $21 trillion yuan a year ago. To the extent that loans fund the demand for something, the $4 trillion yuan decline in those loans means that the demand for the something also declines. In the case of China, the something is the demand for industrial commodities, especially industrial metals (Chart of the Week). Using total social financing rather than the broad money supply reveals a similar downtrend in lending, and therefore a similarly collapsed impulse (Chart I-2 and Chart I-3) But as we explain in the next section, our preference is to focus on China’s broad money supply. Chart I-2Chinese Lending Is ##br##Declining... Chinese Lending Is Declining... Chinese Lending Is Declining... Chart I-3...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed   Declining Chinese Lending Is A Headwind For Metal Demand When interpreting the lending numbers in any economy, there are four important things to keep in mind. First, we should focus on bank lending. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody’s spending power goes down. In contrast, when somebody borrows by issuing a bond, it just reallocates spending power from one person to another. The bond issuer sees his bank account and spending power go up, but the bond buyer sees his bank account and spending power go symmetrically down. Demand will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, and as already mentioned, the impact on economic demand comes from the change in lending – which is to say the credit impulse. This is just to compare apples with apples. Remember that GDP, demand, and lending are all flow statistics. Meaning that the change in demand depends on the change in lending (and not from absolute lending itself).1  Third, the most important part of lending is bank lending to the non-financial sector.2  This is because not all loans generate economic activity. Bank-to-bank lending and reserves held at the central bank stay trapped in the financial system. The money supply – which is on the liabilities side of the banks’ balance sheet – might not pick up this distinction. It could be expanding rapidly due to a surge in bank-to-bank lending and/or in reserves, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending – which is on the assets side of the banks’ balance sheet – and only count lending that is likely to generate economic activity. However, this logic only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. Total social financing includes most, but not all, shadow lending. Yet all shadow lending must eventually show up in the money supply. For this reason, in analysing Chinese lending, we prefer to focus on the broad money supply. Having said that, the messages coming from both the broad money supply and total social financing concur. Chinese lending is slowing. Chinese lending is slowing.  Fourth, we should choose the periodicity of the analysis to maximize its predictive power. This will depend on the specific lead times between the lending and the demand that it is funding, which will be discovered empirically. We find that the 1-year change in China’s broad money supply provides an excellent 1-year lead on industrial metal prices, because the lending leads commodity demand. The obvious rejoinder is, what about tight supply? The answer, from a recent academic paper – Drivers of commodity price booms and busts in the long run – is that for (non-oil) commodities, demand dominates supply. Specifically, “aggregate commodity and commodity-specific demand shocks appear to strongly dominate commodity supply shocks in driving variation in real commodity prices… commodity supply shocks play a rather secondary and transient role.”3 On this basis, we conclude that the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021 (Chart I-4 and Chart I-5). Chart I-4Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Chart I-5...And Iron Ore ##br##Prices ...And Iron Ore Prices ...And Iron Ore Prices   Chinese Lending Is An Investment ‘Super-Driver’ We are strong believers in investment reductionism. Our reductionist philosophy stems from two guiding principles: Occam’s Razor – which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle – which says that 80% of effects come from just 20% of causes.4 Investment banks hate investment reductionism. Given that they want to sell you as much product as possible, they make investment seem much more complicated than it is. Yet most of the moves in most financial markets result from a very small number of ‘super-drivers.’ Our objective is to un-complicate investment – to identify the super-drivers, and to call them right. Clearly, one super-driver right now is the evolution of the pandemic, and specifically the evolution of new variants of the virus, as we discussed in Viral Variants Strike Down The Reflation Trade. A second super-driver is the direction of the T-bond yield, because this drives the direction of many other market trends such as growth versus value, defensives versus cyclicals, and US versus Europe. As we discussed in Don’t Panic About US Inflation, the T-bond yield is likely to drift lower in the coming months. Today’s report identifies a third super-driver – the evolution of Chinese lending. To repeat, the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021.   The sharp drop in Chinese lending over the past year is highly likely to weigh on commodity prices through the remainder of 2021. This means that basic resources equities are likely to underperform both in absolute terms, and relative to the broader market (Chart I-6 and Chart I-7). On a 6-month horizon, go underweight basic resources versus the market. Chart I-6Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Chart I-7...And Relative To The Broad ##br##Market ...And Relative To The Broad Market ...And Relative To The Broad Market It also means that commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar (Chart I-8 and Chart I-9). Chart I-8The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations Chart I-9The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations Commodities Are Fractally Fragile Reinforcing the super-driver of a Chinese lending slowdown, the 260-day fractal structure of the commodity complex is at the same extreme of fragility that heralded turning-points in 2009, 2010, 2018, and 2020 (Chart I-10). Chart I-10The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile As a reminder, a fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. At this point, as longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. Eventually though, when the longer-term investors re-enter the price setting process, the price snaps back towards the valuation anchor. A fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. In early May, we highlighted this fragility in the commodity complex and, exactly as anticipated, most commodities then started to correct. We are trading the on-going correction in commodities through a short position in PKB as well as short CAD/USD, and both positions are now in healthy profit. Staying on the theme of commodities, the 60 percent outperformance of corn versus wheat over the past year is only starting to correct now (Chart I-11). Hence, a recommended trade is to short the corn future (number 2, yellow) versus the wheat future (number 2, soft red) setting the profit target and symmetrical stop-loss at 12 percent. Chart I-11The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct Finally, relating to a non-commodity position, we have extended by 33 days the holding period of short France versus Japan. Thus far, the position has traded sideways so we are giving it more time to move into profit. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The change in lending is the definition of the credit impulse. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Voxeu.org: Drivers of commodity price booms and busts in the long run, David Jacks and Martin Stuermer. 4 Often known as the 80-20 rule. In fact, it could be 90-10, 95-5, or even 100-5 as the numbers do not have to add up to 100. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The Indian rupee is about 7% cheaper than its fair value versus the US dollar. Expanding capital expenditures will boost India’s productivity and raise returns on capital. That will attract higher capital inflows, propelling the rupee. India also has a better inflation outlook compared to the US because of the government’s prudent fiscal policy and muted wage pressures. Foreign bond investors should stay overweight India in an EM local currency bond portfolio. Equity investors should upgrade India from neutral to overweight in view of receding pandemic-related disruptions. Feature The outlook for the Indian rupee over the medium term (six months to three years) is positive. In this report we will identify the two primary drivers of the rupee/US dollar exchange rate over this time horizon. The first is the relative purchasing power in the two economies. The second is return on capital; more specifically, relative return on capital in the two countries. Both indicate that the rupee will likely benefit from a tailwind over the next few years. The robust currency outlook also supports our bullish view on Indian local currency bonds versus their EM peers and US Treasuries. In this report, we will explain how this context, and the Indian market’s own idiosyncrasies, warrants favoring Indian bonds in a global fixed-income portfolio. Finally, we are upgrading Indian stocks back to overweight in an EM equity portfolio. Relative Purchasing Power Chart 1The Indian Rupee Is Below Its Fair Value The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value The concept of “purchasing power parity (PPP)” theorizes that the currency of an economy with higher inflation will adjust lower (i.e., depreciate) relative to the currency of an economy that has lower inflation. The upshot is that the relative inflation dynamics of the two countries could provide insight into their exchange rate outlook.   The top panel of Chart 1 shows that the rupee is currently cheap when measured against what would be its “fair value”. The latter has been derived from a regression analysis between the manufacturers’ relative producer prices of the two countries and the exchange rate. Notably, a deviation from the fair value has also been a good predictor of where the nominal exchange rate will head in the years to come. Whenever the rupee appeared cheap relative to its fair value, it tended to appreciate over the next few years. The opposite has also been true. The current deviation from the fair value implies that the rupee could appreciate by 7% in the coming years (Chart 1, bottom panel). A deeper look into the inflation dynamics reveals that almost all significant directional moves in the rupee-dollar exchange rate over the past 25 years can be explained by movements in the relative inflation differential between the two economies. The rupee typically depreciates versus the dollar when Indian inflation is rising relative to that of the US; and appreciates when the relative inflation is falling. The only times they briefly diverged were during or in the immediate aftermath of a crisis, such as the global financial crisis or the COVID-19 pandemic. However, they were quick to return to their long-term correlations. Relative Inflation Outlook Going forward, the relative inflation outlook favors the rupee. This is because the fiscal and monetary policies in India will likely be tighter in India than in the US for the foreseeable future. Incidentally, India’s core inflation has fallen significantly relative to that of the US in the past decade (Chart 2). India’s inflation is driven mainly by two factors. The first is food prices; more specifically, the “minimum support price” that the Indian government pays to the farmers to procure food grains. Since the government is by far the single largest purchaser, the price it pays usually sets the floor in the market. The ebbs and flows of this procurement price have had a telling impact on the country’s inflation over the past few decades (Chart 3, top panel). Chart 2India's Inflation Has Fallen Significantly In The Past Decade The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 3Notwithstanding The Temporary Pandemic-Era Surge In Fiscal Spending … The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   In recent years, however, the authorities have been careful and did not hike the procurement prices over much. That has helped to keep headline CPI in check. Further, the government legislated new farm laws last year, which will usher in private capital in the agriculture sector. This will help improve farm productivity and keep food prices under control1 in the future.  Chart 4...Fiscal Policy Has Been Very Prudent Since The GFC The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value The other driver of Indian inflation is fiscal expenditure. The rise and fall in government spending leads core inflation by about a year (Chart 3, bottom panel). Notably, even though fiscal spending has swelled over the past year to provide relief to a pandemic-stricken economy, this one-off surge is offset by collapse in output and demand. Besides, the odds are high that the government will revert to a tighter stance as soon as the pandemic is brought under control. Indeed, such a fiscal splurge represents a departure rather than a fixture in India’s fiscal policy. Ever since the global financial crisis, successive Indian governments adopted a rather prudent fiscal stance. Chart 4 shows that fiscal spending steadily declined from 17% of GDP in 2009 to 12% by 2019. The conservative stance was implemented by both the previous UPA government and the current NDA government which came to power in 2014. Such a stance not only helped to substantially reduce the country’s fiscal and primary deficits but was also instrumental to the steady decline in inflationary pressures. The wage pressures in the economy are also rather muted. In rural areas, both farm and non-farm wages have been growing at a slow pace and have often remained below consumer inflation for the past six years (Chart 5, top panel). A similar picture is seen in the central banks’ (RBI) industrial outlook surveys. The assessment for salary and remuneration shows a subdued outlook; in fact, the indicator is below zero (Chart 5, bottom panel). This implies that wage pressures in the industrial sector have also been very low since 2017. Going forward, as tens of millions of young people continue to join the work force every year, the broader picture is unlikely to change. Overall, subdued wage pressures will also keep a tab on general inflation in the economy. Relative Return On Capital The other important driver of the rupee versus the dollar over the medium term is the direction of Indian companies’ return on capital relative to those of the US. When the return on capital rises, especially relative to that of the US, foreign capital flows into India in search of higher profits. Those capital inflows help boost the rupee. Chart 6 shows that over the past 25 years the rupee strengthened versus the dollar during those periods when return on assets of Indian non-financial corporates rose. The rupee depreciated when this ratio dropped. Chart 5Inflation Outlook Remains Sanguine As Wage Pressures Are Muted The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 6Rupee Strengthens When Relative Return On Capital In India Rises... The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   The same holds true when Indian firms’ return on assets are compared relative to those of the US. All major moves in rupee strength and weakness largely coincided with the relative rise and fall in return on assets (Chart 6, bottom panel). Chart 7...As Foreign Capital Inflows Into India Boosts The Rupee The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Thus, relative profitability clearly has a major influence on the exchange rate. And as alluded to earlier, the link is via capital inflows. The ebbs and flows of capital into India have a very explicit impact on the rupee (Chart 7). Going forward, a pertinent question is in which way will India’s return on capital be headed. Our bias is that, beyond the pandemic-related disruptions, it is heading higher over the medium term. We have the following observations: A sustainable rise in return on capital is highly contingent on productivity gains. And the latter depends on capital investment in new plants, machinery, technology, as well as on infrastructure. Thus, a meaningful and sustained rise in capital expenditures could be a harbinger of higher returns in the future. Firms, on their part, would engage in new capital expenditures once they are sanguine of future demand as well as profits. Notably, both gross and net profits of India’s non-financial sector have rebounded rather strongly. Capital expenditure has recovered in tandem (Chart 8). The latter indicates that companies do not consider profit recovery a fluke and are confident demand will remain upbeat. Corroborating the above, imports of capital goods have skyrocketed. This is also a precursor to higher capex down the road (Chart 9). Chart 8Rebounding Profits Have Encouraged Firms To Resume Capex... The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 9...As Evidenced In Accelerating Capital Goods Imports The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 10Capital Goods Imports Have Been Rising For The Past Several Years The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Markedly, India’s import profile has been encouraging in recent years. The share of capital goods in total imports and non-oil imports have been rising (Chart 10). This indicates that firms have not been averse to capital expenditure. This also shows that unlike in some other EM countries, imported consumer goods did not overwhelm India’s capital goods imports. The last time India saw a surge in capital goods imports was in the 2000s, a period when the country’s capex and profits also surged. That period coincided with a multi-year bull run in the rupee and stocks. The early 2010s, on the other hand, saw a deceleration in capex and capital goods imports – and was followed by a period of sub-par return on capital. Now, the tides are turning again. Finally, the quality of capital inflows has also improved over the past decade. India has been receiving ever higher amounts of FDI compared to portfolio inflows (Chart 11). The former is a much more efficient form of capital and are also more likely to boost capital expenditures enhancing productivity in the economy. Incidentally, India’s real gross fixed capital formation has hovered between 30% and 35% of GDP since 2008 – easily the highest rate globally, save China (Chart 12). Hence, if a new capex cycle ensues, which seems likely, it will happen over and above the base built over the past decades. That should help drive labor productivity and profits up by a notch. Chart 11...Along With Steady Growth In FDI The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 12A New Capex Cycle On Top Of The Previous Base Will Boost Productivity The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   All in all, odds are that Indian productivity will improve going forward, which in turn will boost firms’ profitability metrics. That should help propel the rupee. Bond Bullish The combination of a stable currency, prudent fiscal policy, and a benign inflation outlook make Indian bonds highly desirable to foreign investors. Notably, thanks to some systemic factors, Indian bonds are not as sensitive to bouts of fiscal profligacy and/or inflation in India: Over the past 20 years or so, ten-year bond yields hovered in a rather narrow band of 6%- 9%. A crucial reason for that stability is very limited foreign holdings: only about 2% of Indian government bonds are held by foreign investors. This has reduced yield volatility substantially. In many EM countries, where foreign holdings are much higher, a negative growth shock usually leads to both rising bond yields and a depreciating currency – which perpetuate each other – as foreign investors head for the exit. In the case of India, a negative shock is tempered by falling bond yields, as domestic investors switch from riskier assets to government bonds. Not only are the foreign holdings in India too small to push up yields but the falling yields also encourage them to stay invested. That explains why bond yields in India fell during each of the crises: in 2008-09, 2014-15 and more recently in 2020. A second reason is the existence of captive domestic bond investors: commercial banks. As per the Reserve Bank of India mandate, all banks in India are obligated to hold a certain percentage (currently 18%) of their total deposits in government securities (called Statutory Liquidity Ratio, or SLR). These mandatory holdings have also helped reduce yield volatility. The impact of the above factors can often be seen at play. For one, a surge in India’s fiscal expenditure does not necessarily cause a spike in bond yields. This is because, devoid of any fear of dumping by foreign bond holders, India can and does ramp up government spending when growth is very weak. Those are the times when domestic investors shed riskier assets and move to the safety of government bonds. Hence, we see accelerating fiscal spending coinciding with low and falling bond yields, unlike in many other EM countries (Chart 13, top panel).   For a similar reason, a surge in India’s fiscal deficit does not necessarily cause a spike in bond yields either. If anything, widening budget deficits usually coincide with falling bond yields; and shrinking deficits with rising bond yields (Chart 13, bottom panel).  The explanation for this apparent anomaly is as follows: periods of stronger growth bring in more fiscal revenues and thus reduce the deficit. But strong growth and rising inflationary pressures also lead to higher interest rate expectations reflected in higher bond yields. The opposite happens when growth slows. Even though fiscal deficit goes up as revenues drop, decelerating inflationary pressures pave the way for lower bond yields. A pertinent question here is, given the idiosyncrasies of Indian bond markets, what then drives Indian bond yields? The simple answer is the business cycle. This is why rising bond yields coincide with stronger bank credit growth and falling yields with weaker credit growth (Chart 14). Chart 13A Surge In Fiscal Spending Or Deficits Doesn't Mean A Spike In Bond Yields The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 14The Business Cycle Is The Ultimate Driver Of Indian Bond Yields The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   What is also notable is that the impact of any spike in consumer and/or producer price inflation on bond yields is not very pronounced (Chart 14, bottom panel). A crucial reason for that is again the SLR. Because of it, regardless of commercial banks’ own inflation expectations, they cannot dump government bonds. That puts a cap on bond yields even when inflation is rising. Besides, a rise in inflation usually coincides with accelerating bank credit and bank deposits. The latter causes higher demand for government bonds from banks (to maintain SLR). That in turn helps keep the bond yield lower than it otherwise would be. Chart 15The Spike In Public Debt Is Temporary, And Bond Investors Are Not Worried The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Bottom Line: The absence of foreign investors, the presence of large captive domestic investors and a long-held orthodox fiscal stance have turned the Indian bond market into a different ball game than many other EM local currency bond markets. One takeaway from this idiosyncrasy is that the current steep, but temporary, fiscal deficit should not be a matter of concern for bond investors. For a similar reason, the recent rise in the public debt-to-GDP ratio should have little impact on bond yields (Chart 15). Finally, a moderate rise in inflation is also unlikely to cause Indian bond yields to soar. Investment Conclusions The medium-term outlook for the Indian rupee is positive. It is also quite competitive, especially when compared to the currencies of India’s major competitors vying for multinationals to establish their manufacturing capacity (Chart 16). This means the rupee has some room for nominal appreciation without hurting its competitiveness. Chart 16The Indian Rupee is Quite Competitive The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value This emphasizes our view that investors should continue to overweight India in an EM fixed-income portfolio. While strong growth and higher US bond yields can drive up Indian government bond yields, the former will also push up the rupee – as detailed in a previous section. The currency returns will offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Notably, because of the latter, a similar rise in yields (say, 100 basis points) in India and US bonds will have a much less negative impact on total return terms for Indian bonds than in the case of US Treasurys.  The long end of the Indian yield curve offers value: the 10-year bond yield is 200 basis points above the policy rate. The spread of India’s 5-year bond over that of the US is an impressive 550 basis points (Chart 17, top panel). Given the sanguine rupee outlook, odds are that Indian government bonds will continue to outpace US treasuries in total return terms – even when Indian growth accelerates and inflation rises modestly (Chart 18). Chart 17Indian Bonds Offer Value Relative To US And EM Counterparts The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 18Higher Carry And A Stronger Currency Will Lead To Total Return Outperformance The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value When compared to the same-duration JP Morgan GBI-EM bond index, India offers a spread of 100 basis points. India has steadily outperformed that index in US dollar total return terms over the past several years (Chart 17, bottom panel). That is unlikely to change in future, thanks to the high carry and a relatively more stable currency. As such, investors should stay on with our recommendation of overweighting India in an EM local currency bond portfolio (Chart 18). Chart 19Go Overweight Indian Stocks In An EM Equity Portfolio The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Several factors that make the outlook for the rupee positive also argue for a positive outlook for Indian stocks. Like most other EM currencies, the rupee is pro-cyclical, and it tends to move with Indian share prices. Notably, Indian stocks have broken out of their previous highs (Chart 19). On a separate note, as the number of daily COVID-19 cases in the country have subsided, so have the chances of debilitating lockdowns. As such, economic activity is slated to gather steam. We had tactically downgraded India from overweight to neutral in an EM equity portfolio on April 22 in view of skyrocketing COVID-19 cases and deaths back then. Even though the pandemic situation had deteriorated considerably after our downgrade, share prices have staged a nice rebound to our surprise. It’s time to upgrade this bourse back to overweight (Chart 19, bottom panel). Investors should also stick with our sectoral recommendation of long Indian Banks and short EM banks. As we elaborated in our report on Indian banks, a recovery in the business and capex cycles would be very positive for Indian private sector banks (that make up 90% of the MSCI India Banks index) – given that they have aggressively cleansed their balance sheets of NPLs and have thereby already taken the hit in their earnings. Fixed-income investors should close the trade of receiving 10-year swap rates in India. We had recommended it along with other EM local rates back in April 2020 as a play on lower interest rates in EM. India’s 10-year swap rates have risen by 166 basis points since then. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 For more details see our report India’s Reform Drive: How Momentous (Part 1) dated 19 November 2020.

Highlights Economy – We agree with the Fed’s judgment that sky-high inflation readings will not last: Used-car prices won’t go up forever and neither will airline fares or hotel accommodations. Supply bottlenecks affecting the prices of a wide range of goods will eventually ease. Markets – If growth is too strong for a recession but not so strong that it forces the Fed to induce a recession, equities and spread product will outperform Treasuries: Uncertainty surrounds the post-pandemic economy, but our base case is that the US will be able to grow well above trend in 2021 and 2022 without triggering uncomfortably high inflation. Strategy – Investors should remain at least equal weight risk assets in multi-asset portfolios: A strong-growth, easy-policy backdrop is good for equities and credit and investors should maintain exposure to them in balanced portfolios. Feature The unprecedented nature of the current economic backdrop, in which a global pandemic causes the US to idle large swaths of the economy, inject previously unimaginable amounts of aid to households and businesses to help them withstand its ravages, then attempt to restart the idled elements more than a year later, allows a lot of room for interpretation. One can see just about whatever one wants to see in the incoming flow of data as it is highly uncertain how long it will take the many individual engines to hum after their switches are flipped back to ON from OFF. Investors are charged with getting ahead of moves in forward-looking markets, however, and want to know now what awaits around the bend. Amidst the flow of often contradictory data points, we strive to maintain our focus on the broad overarching trend. We continue to find the Goldilocks-and-the-Two-Tails framework helpful in keeping our eye on the ball (Figure 1). Our base case remains that the just-right strong-growth/accommodative-monetary-policy backdrop will remain in place for the balance of our three-to-twelve-month cyclical investment time frame. COVID-19’s apparent retreat in the US1 leads us to believe that the too-cold left-tail outcome, characterized by disappointingly slow growth, is increasingly unlikely (Chart 1). Figure 1Goldilocks And The Two Tails Checking In With The Inflation Checklist Checking In With The Inflation Checklist Chart 1The Pace Has Slowed, But A Lot Of Americans Are Already Vaccinated The Pace Has Slowed, But A Lot Of Americans Are Already Vaccinated The Pace Has Slowed, But A Lot Of Americans Are Already Vaccinated Table 1Inflation Checklist Checking In With The Inflation Checklist Checking In With The Inflation Checklist The right-tail outcome in which the economy overheats looks more probable and it is our primary concern. Overheating would bring uncomfortably high rates of consumer price inflation and we devote this week’s report to a review of our inflation checklist (Table 1). The checklist is not meant to identify the moment that inflation becomes a mortal threat to the expansion. We will not sound the alarm and adjust our asset allocation recommendations the instant that a pre-determined number of boxes are checked; it is simply meant to provide us with a systematic framework for assessing its movements and their implications for financial markets and the economy. Labor Market Indicators Chart 2Wages Are Not Yet A Hot Spot Wages Are Not Yet A Hot Spot Wages Are Not Yet A Hot Spot The executive summary of last week’s examination of the labor market is that we expect the factors constraining supply will ease considerably by the fall as the services sector fully reopens, in-person learning resumes for all K through 12 students and federal supplements to unemployment insurance benefits expire. Demand for workers remains robust, with the JOLTS job openings rate and the NFIB survey’s unfilled job openings series making new highs. The combination of potent demand and constrained supply is not producing wage inflation, however. The Atlanta Fed’s wage tracker, which follows the same set of employees over time, has rolled over and is now nearly a full point below its post-GFC peak (Chart 2, middle panel); the employment cost index, which also adjusts for changes in labor force composition, is rising but remains near the bottom of its pre-GFC range (Chart 2, bottom panel); and the less-sophisticated average hourly earnings series has dipped below 2% (Chart 2, top panel). Price Indexes Checking the Marquee Indexes box was a no-brainer after the core CPI and core PCE price index made new multi-year highs in May. The question going forward is whether the surge in consumer prices is a one-off or a harbinger of a lasting change. We remain in the one-off camp with the Fed, figuring that the bottlenecks that have pushed month-over-month gains in the price indexes to multi-decade highs are a function of trying to ramp up production to more normal levels after a year-plus interruption. The trimmed-mean measures of core CPI and PCE send a much less worrisome message and suggest that once the bottlenecks driving outlier price increases are resolved, the marquee measures will settle down as well (Chart 3). Chart 3Trimmed-Mean Price Indexes Are Still Well Behaved Trimmed-Mean Price Indexes Are Still Well Behaved Trimmed-Mean Price Indexes Are Still Well Behaved Pipeline Pressures BCA’s pipeline inflation pressure index did not let up in May (Chart 4, top panel), indicating that components like the CRB Raw Industrials Index are still pushing higher, reinforcing our Commodity and Energy Strategy team’s view that several years of tepid investment have left base metals and energy markets with supply deficits that will push prices higher into the intermediate term. The DXY index tested multi-year support at 90 but is holding above it for now (Chart 4, bottom panel), staving off the increase in import prices that could result from a technical breakdown in the dollar. There is also little direct inflation pressure coming from overseas, as consumer prices in the Eurozone and China, the two biggest economies outside of the US, remain contained (Chart 5). Chart 4Pipeline Pressures Have Not Eased, But The Dollar Staved Off An Inflationary Breakdown Pipeline Pressures Have Not Eased, But The Dollar Staved Off An Inflationary Breakdown Pipeline Pressures Have Not Eased, But The Dollar Staved Off An Inflationary Breakdown Chart 5China And The Eurozone Aren't Exporting Inflation Pressures To The US Yet China And The Eurozone Aren't Exporting Inflation Pressures To The US Yet China And The Eurozone Aren't Exporting Inflation Pressures To The US Yet Inflation Expectations Chart 6Markets Still Expect The Rate Of Inflation To Slow Over Time Markets Still Expect The Rate Of Inflation To Slow Over Time Markets Still Expect The Rate Of Inflation To Slow Over Time The inflation expectations curve as derived from market-based measures remains inverted, indicating that investors agree with the Fed’s transitory inflation assessment. The message is the same as it was last month when we showed the TIPS break-even and CPI swap rates for the 2-to-5- and 5-to-10-year periods, though there have been some adjustments across the segments. The 2-to-5-year segment has become more inverted (Chart 6, top and third panels), which is to say that investors expect a larger drop-off in inflation in years three, four and five versus years one and two, while the 5-to-10-year segment has become less inverted (Chart 6, second and bottom panels). The curves still point to declining long-term inflation after a near-term spike, however, as inflation is projected to fall in years 3 to 5 and then hold steady (TIPS) or rise slightly (CPI swaps) in years 6 to 10 (Table 2). We find market-based measures to be more insightful than survey measures, but we were encouraged to see the University of Michigan consumer survey data follow the same pattern. The median 1-year inflation expectation, at 4% (down 60 basis points (“bps”) from May), was 120 bps above the median 5-year inflation expectation of 2.8% (down 20 bps from May’s reading). The New York Fed’s April Survey of Market Participants had 5-year-on-5-year CPI inflation rising, albeit at a modest level that demonstrated market professionals’ inflation expectations remain well anchored. The respondents’ median forecast for the annual rate of inflation from April 2026 through March 2031 was 2.2%, slightly above their 2.1% median forecast from April 2021 through March 2026. Table 2Investors Agree That Inflation Will Be Transitory Checking In With The Inflation Checklist Checking In With The Inflation Checklist The Fed’s Reaction Function The June FOMC meeting accorded with our expectations. The post-meeting statement acknowledged the economy’s improvement as waning infections and an effective vaccination campaign have pushed the pandemic off of center stage. Meeting participants pulled their median liftoff date expectation into 2023 from 2024, aligning “the dots” more closely with financial markets and our own late-2022 view (Chart 7). They also significantly raised their 2021 inflation expectations from March, which had been trampled by the April and May CPI and PCE index releases. Chart 7Much Ado About A Modest Tweak Much Ado About A Modest Tweak Much Ado About A Modest Tweak We were therefore surprised that the meeting produced so much excitement in financial markets. Treasuries gyrated, with yields soaring across all maturities Wednesday afternoon before long-dated issues unwound most of their backup (the 10-year note) or made new multi-month lows (the 30-year bond) in Thursday’s session. Yields at the short end of the curve stayed higher as the bond market moved its liftoff date expectations forward, with the net result that the Treasury curve flattened. The dollar popped, precious metals were hammered, and the NASDAQ rose while banks took a hit. We included the Fed reaction function items in our inflation checklist as a way of highlighting that the high-inflation end game will proceed once fed funds rate hikes are directed at containing it. When we introduced the checklist last month, we wrote that we would only check the Fed boxes in the event that Fed speakers begin to telegraph a change of direction or if the dots indicated that the bias toward accommodative policy was shifting. We do not think last week’s recognition that the March Summary of Economic Projections (SEP) had gone stale in the wake of subsequent data releases constitutes a change in the Fed’s accommodative stance. As a Wall Street Journal editorial lamenting that bias (and the administration’s ambitious spending plans) put it,2 Which of the following doesn’t fit with the others? A) 7% GDP growth in 2021. B) 5% and 3.8% year-over-year increases in CPI and core CPI, respectively. C) 4.5% unemployment by year-end, on its way to 3.8% at year-end 2022. D) A near-zero fed funds rate for two more years. As long as the Fed finds a way for D) to coexist with A), C) and whatever B) turns out to be over the ensuing months as transitory inflation pressures abate, there will be no need to check our reaction function boxes. Investors won’t have any need to get overweight benchmark duration to position for a cyclical rally in Treasuries, either. Why Bother? Our US Bond Strategy colleagues have noted that the inflation-related criteria for hiking rates have been met. Year-over-year PCE inflation is above 2% and with the SEP’s median headline and core projections for 2021 PCE inflation at 3.4% and 3%, respectively, it is on track to exceed 2% for some time. If the Fed abides by the specific guidance it has repeatedly outlined, the beginning of the next rate-hiking cycle will depend on the state of the labor market. An investor who wants to position for the cyclical inflection in Treasury yields will be best served by anticipating the path of nonfarm payrolls. We will continue to keep tabs on our inflation checklist, however, because inflation is an important tail risk. We are asked about it in every meeting and it is a hot topic in the general media as well. If households, businesses and investors were to become convinced that a new worrisome inflation regime had begun, financial markets and the economy would be roiled. Even though such a scenario lies outside of our base case, we will track it and think about how to navigate it on the general principle that we would rather be ready than have to get ready.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The 7-day averages of new cases and deaths have fallen all the way to their late March 2020 levels. 2https://www.wsj.com/articles/no-inflation-worries-at-the-fed-11623883322 Accessed June 17, 2021.

Dear Client, Next week, instead of our regular report, we will be sending you a Special Report from BCA Research’s MacroQuant tactical global asset allocation team. Titled “MacroQuant: A Quantitative Solution For Forecasting Macro-Driven Financial Trends,” this white paper will discuss the purpose, coverage, and methodology of the MacroQuant model. I hope you will find the report insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets for the rest of 2021 and beyond. We will also be holding a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) to discuss the outlook. Best regards, Peter Berezin Chief Global Strategist Highlights Although the Fed delivered a hawkish surprise on Wednesday, monetary policy is likely to remain highly accommodative for the foreseeable future. We continue to see high US inflation as a long-term risk rather than a short-term problem. Outside of a few industries, wage inflation remains well contained. In those industries suffering from labor shortages, the expiration of emergency unemployment benefits, increased immigration, and the opening up of schools should replenish labor supply. Bottlenecks in the global supply chain are starting to ease. Many key input prices have already rolled over, suggesting that producer price inflation has peaked and is heading down. A slowdown in Chinese credit growth could weigh on metals prices during the summer months, which would further temper inflationary pressures. We are downgrading our view on US TIPS from overweight to neutral. Owning bank shares is a cheaper inflation hedge. Look Who’s Talking The Fed jolted markets on Wednesday after the FOMC signaled it may raise rates twice in 2023. Back in March, the Fed projected no hikes until 2024 (Chart 1). Chart 1Fed Forecasts Converge Toward Market Expectations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Seven of 18 committee members expected lift-off as early as 2022, up from four in March. Only five participants expected the Fed to start raising rates in 2024 or later, down from 11 previously. The Fed acknowledged recent upward inflation surprises by lifting its forecast of core PCE inflation to 3.4% for 2021 compared with the March projection of 2.4%. These forecast revisions bring the Fed closer to market expectations, although the latter are proving to be a moving target. Going into the FOMC meeting, the OIS curve was pricing in 85 bps of rate tightening by the end of 2023. At present, the market is pricing in about 105 bps of tightening. At his press conference, Chair Powell acknowledged that FOMC members had discussed scaling back asset purchases. “You can think of this meeting as the ‘talking about talking about’ meeting,” he said. A rate hike in 2023 would imply the start of tapering early next year. The key question for investors is whether this week’s FOMC meeting marks the first of many hawkish surprises from the Fed. We do not think it does. As Chair Powell himself noted, the dot-plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” Ultimately, a major monetary tightening cycle would require that inflation remain stubbornly high. As we discuss below, while there are good reasons to think that the US economy will eventually overheat, the current bout of inflation is indeed likely to be “transitory.” This implies that bond yields are unlikely to rise into restrictive territory anytime soon, which should provide continued support to stocks. Inflation: A Long-Term Risk Rather Than A Short-Term Problem Chart 2Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago There are plenty of reasons to worry that US inflation will eventually move persistently higher. As we discussed in a recent report, many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 2). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over unruly global supply chains. Baby boomers are leaving the labor force en masse. As a group, baby boomers control more than half of US wealth (Chart 3). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Chart 3Baby Boomers Have Accumulated A Lot Of Wealth Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Despite a pandemic-induced bounce, underlying productivity growth remains disappointing (Chart 4). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 5). Chart 4Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Chart 5Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Perhaps most importantly, policymakers are aiming to run the economy hot. A tight labor market will lift wage growth (Chart 6). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Despite these structural inflationary forces, history suggests that it will take a while – perhaps another two-to-four years – for the US economy to overheat to the point that persistently higher inflation becomes a serious risk. Consider the case of the 1960s. While the labor market reached its full employment level in 1962, it was not until 1966 – when the unemployment rate was a full two percentage points below NAIRU – that inflation finally took off (Chart 7). Chart 6A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In May, 4.4% fewer Americans were employed than in January 2020 (Chart 8). The employment-to-population ratio for prime-aged workers stood at 77.1%, 3.4 percentage points below its pre-pandemic level (Chart 9). Chart 8US Employment Still More Than 4% Below Pre-Pandemic Levels Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 9Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels A Labor Market Puzzle Admittedly, if one were to ask most companies if they were finding it easy to hire suitable workers, one would hear a resounding “no.” According to the National Federation of Independent Business (NFIB), 48% of firms reported difficulty in filling vacant positions in May, the highest share in the 46-year history of the survey (Chart 10). Chart 10US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 11US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Nationwide, the job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The share of workers quitting their jobs voluntarily – a measure of worker confidence – also hit a record of 2.7% (Chart 11). How can we reconcile the apparent tightness in the labor market with the fact that employment is still well below where it was at the outset of the pandemic? Four explanations stand out. First, unemployment benefits remain extremely generous. For most low-wage workers, benefits exceed the pay they received while employed. It is not surprising that labor shortages have been most pronounced in sectors such as leisure and hospitality where average wages are relatively low (Chart 12). The good news for struggling firms is that the disincentive to working will largely evaporate by September when enhanced unemployment benefits expire. Chart 12Labor Scarcity Prevalent In Low-Wage Sectors Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 13School Closures Have Curbed Labor Supply Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Second, lingering fears of the virus and ongoing school closures continue to depress labor force participation. Chart 13 shows that participation rates have recovered less for mothers with young children than for other demographic groups. This problem will also fade away by the fall when schools reopen. Third, the number of foreign workers coming to the US fell dramatically during the pandemic. State Department data show that visas dropped by 88% in the nine months between April and December of last year compared to the same period in 2019 (Chart 14). President Biden revoked President Trump’s visa ban in February, which should pave the way for renewed migration to the US. Chart 14US Migrant Worker Supply Is Depressed Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 15The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement   Fourth, about 1.5 million more workers retired during the pandemic than one would have expected based on the pre-pandemic trend (Chart 15). Most of these workers were near retirement age anyway. Thus, there will likely be a decline in new retirements over the next couple of years before the baby boomer exodus described earlier in this report resumes in earnest. Other Input Prices Set To Ease Just as labor shortages in a number of industries will ease later this year, some of the bottlenecks gripping the global supply chain should also diminish. The prices of various key inputs – ranging from lumber, steel, soybeans, corn, to DRAM prices – have rolled over (Chart 16). This suggests that producer price inflation for manufactured goods, which hit a multi-decade high of 13.5% in May – has peaked and is heading lower. Chart 16Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over The jump in prices largely reflected one-off pandemic effects. For example, rental car companies, desperate to raise cash at the start of the pandemic, liquidated part of their fleets. Now that the US economy is reopening, they have found themselves short of vehicles. With fewer rental vehicles hitting the used car market, households flush with cash, and new vehicle production constrained by the global semiconductor shortage, both new and used car prices have soared. Vehicle prices have essentially moved sideways since the mid-1990s (Chart 17). Thus, it is doubtful that the recent surge in prices represents a structural break. More likely, prices will come down as supply increases. According to a recent report from Goldman Sachs, auto production schedules already imply an almost complete return to January output levels in June. Chart 17Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Chart 18Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet As Chart 18 shows, more than half of the increase in consumer prices in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI remains below its pre-pandemic trend (Chart 19). Chart 19Unwinding Of "Base Effects" Unwinding Of "Base Effects" Unwinding Of "Base Effects"   Chart 20"Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained More refined measures of underlying inflation such as the trimmed-mean CPI, median CPI, and sticky price CPI are all running well below their official core CPI counterpart (Chart 20). While certain components of the CPI basket, such as residential rental payments, are likely to exhibit higher inflation in the months ahead, others such as vehicle and food prices will see lower inflation, and perhaps even outright deflation. Slower Chinese Credit Growth Should Temper Commodity Inflation Chart 21Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese credit growth and base metals prices are strongly correlated (Chart 21). We do not expect the Chinese authorities to embark on a new deleveraging campaign. Credit growth has already fallen back to 11%, which is close to the prior bottom reached in late-2018. Nevertheless, to the extent that changes in Chinese credit growth affect commodity prices with a lag of about six months, metals prices could struggle to maintain altitude over the summer months. China’s plan to release metal reserves into the market could further dampen prices. We remain short the global copper ETF (COPX) relative to the global energy ETF (IXC) in our trade recommendations. The trade is up 18.4% since we initiated on May 27, 2021. We will close this trade if it reaches our profit target of 30%. Bank Shares Are A Better Hedge Against Inflation Than TIPS We have been overweight TIPS in our view matrix. However, with 5-year/5-year forward breakevens trading near pre-pandemic levels, any near-term upside for inflation expectations is limited (Chart 22). As such, we are downgrading TIPS from overweight to neutral in our fixed-income recommendations. Investors looking to hedge inflation risk should consider bank shares. Our baseline view is that the 10-year Treasury yield will rise to about 1.9% by the end of the year. If inflation fails to come down as fast as we anticipate, bond yields would increase even more than that. Chart 23 shows that banks almost always outperform the S&P 500 when bond yields are rising. Chart 22Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Chart 23Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Banks are also cheap. US banks trade at 12.2-times forward earnings compared with 21.9-times for the S&P 500. Non-US banks trade at 10-times forward earnings compared to 16.4-times for the MSCI ACW ex-US index. Finally, we like gold as a long-term inflation hedge. We would go long gold in our structural trade recommendations if the price were to fall to $1700/ounce. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Special Trade Recommendations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Current MacroQuant Model Scores Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Tightening Pressures... Tightening Pressures... Chart 1B… Everywhere ...Everywhere ...Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. The Surging CB Monitors... The Surging CB Monitors... Chart 2B… Suggest More Upside For Bond Yields ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising All BoE Monitor Components Are Rising All BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Inflation Components Lagging Inflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor The BoJ Monitor The BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected No Change In Policy Expected No Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD A Positive Story For The CAD A Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor The Norges Bank Monitor The Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor The SNB Monitor The SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades