Inflation/Deflation

Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist   Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth.   Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20.  From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally.  We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2).  Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4).  Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line:  It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed.  In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again Housing Market Heats Up Again Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy.  Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12).  Chart 11Labor Market Is On The Mend Labor Market Is On The Mend Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year.   Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks.    Jing Sima China Strategist jings@bcaresearch.com   Footnote: 1     IMF World Economic Outlook and World Bank Global Outlook, January 2021   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights US inflation expectations will continue to grind higher as commodity markets tighten, and financial markets price to an ultra-accommodative Fed over the next 2-3 years. The US stock-market rally is reducing equity yields and squeezing equity risk premiums, which acts as a drag on gold prices.  Higher earnings, lower stock prices or both are needed to reduce this effect. Pandemic uncertainty continues to fuel safe-haven demand for the USD, which remains a headwind for gold and silver.  Vaccination availability needs to reach a level that convinces markets global contagion risk has been minimized.  Until then, this remains the dominant downside risk to gold and commodities. The balance of risks continues to favor gold: US real rates will remain weak as the Fed remains behind the inflation-vs-rates curve, and the USD will be pushed lower (Chart of the Week).  We continue to expect gold prices to push to $2,000/oz. We remain bullish silver, and view the recent retail-spec price blip as transitory.  Fundamentally, silver supply growth is weakening, and demand is strengthening as the renewable-energy buildout accelerates and consumer spending revives.  We expect silver's price to trade back to $30/oz.  Feature US inflation expectations will continue to grind higher, as tightening markets for industrial commodities push oil and base metals prices higher (Chart 2).1 As is apparent in Chart 2, these real-economy factors feed directly into five-year inflation expectations, which are important to policy makers and portfolio managers managing risk in trading markets.2 Continued Fed accommodation of massively expansive US fiscal policy also will stoke inflation expectations, and keep real rates negative or weak at low positive levels as realized inflation and inflation expectations increase. These real and financial effects will be positive for gold prices, as the Chart of the Week illustrates. Chart of the WeekRising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Rising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Rising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Chart 2Tightening Commodity Markets Push Inflation Expectations Higher Tightening Commodity Markets Push Inflation Expectations Higher Tightening Commodity Markets Push Inflation Expectations Higher Battling against this tailwind is the historic US equity rally, which has crushed stock yields and the equity risk premium vs bond yields.3 Gold prices are positively correlated with equity risk premiums – the positive economic forces that push dividend yields higher also tend to push gold and commodity prices higher – which means the falling risk premiums are acting as a headwind to gold prices (Chart 3).4 If, as the global economy recovers, the rate of growth in earnings is greater than that of equity prices, stock yields will expand, which will be supportive of gold prices. That said, we do not expect the contraction of the equity risk premium to dominate the evolution of gold prices. Tightening fundamentals in the real economy and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics. Chart 3Falling Stock Yields Pressure Equity Risk Premiums Falling Stock Yields Pressure Equity Risk Premiums Falling Stock Yields Pressure Equity Risk Premiums Balance of Risks Favors Gold Fed policy pronouncements point to continued accommodation of massive fiscal stimulus in the US, with the central bank strongly indicating it will, as a matter of policy, remain behind the inflation-vs-rate-hikes curve for at least another 2-3 years. Taking the Fed at its word, this means US real rates will remain weak, and the USD will be pushed lower as the central bank continues to accommodate higher US budget deficits at the federal level. However, as we have repeatedly noted, the broad trade-weighted USD has found strong support at current levels following a precipitous fall from its COVID-19-induced highs in 1Q20: As pandemic uncertainty feeds into global policy uncertainty, USD safe-haven demand remains elevated (Chart 4).5 While we concentrate on five-year inflation expectations in our modeling, indications of price pressures are showing up in the manufacturing sector in the US (Chart 5), as our colleagues in BCA Research’s US Bond Strategy note in their report this week.6 This confirms that the price strength seen in commodity markets for raw materials used in manufacturing are showing up in the economy as a whole. Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Chart 5Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up Our price target for gold remains $2,000/oz. The sooner vaccines are deployed globally – so that markets can reasonably assign lower odds to a resurgence of COVID-19 and its more insidious variants forcing new lockdowns – the sooner the pandemic uncertainty keeping the USD well bid will dissipate as a fundamental factor restraining a continuation of gold’s rally. Silver Is Not GameStop The Reddit-powered surge in retail silver trading this past week, which lifted silver prices some ~ 11% on Monday to $30/oz, is all but a memory now that the white metal is again pricing in line with fundamentals. We turned bullish silver in July of last year, arguing fundamentals suggested silver could outperform gold in 2H20, which it did.7 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 6). We expect the supply side of the market to remain under pressure this year and the next, given the physical deficits we are forecasting for the copper market over the next two year: The supply side of silver is a function of copper, zinc and lead mine output (i.e., silver largely is a byproduct). On the demand side, continued recovery of consumer spending and the decade-long buildout of renewable-energy generation – which is heavily reliant on copper and silver to a lesser degree – will force prices higher. We remain bullish silver. However, given our expectation its price will trade again to $30/oz, we do not expect any dramatic tightening of the gold/silver ratio this year (Chart 7). Chart 6Silver Market Tightens, Along With Other Commodities Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets Chart 7Expect Gold/Silver Ratio To Continue To Narrow Expect Gold/Silver Ratio To Continue To Narrow Expect Gold/Silver Ratio To Continue To Narrow Bottom Line: Tightening commodity fundamentals and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics this year and the next. The contraction of the equity risk premium will not dominate the evolution of gold prices. At the margin, if earnings growth exceeds  equity-price increases, equity yields will expand, which will support gold prices. We expect gold and silver to trade to $2,000/oz and $30/oz this year – i.e., close to ~ 10% gains for both. Therefore, we do not expect much movement in the gold/silver ratio this year   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0’s Joint Technical Committee (JTC) lowered its estimated demand growth for 2021 to 5.6mm b/d from its 5.9mm b/d estimate last month, at its Tuesday meeting. The JTC also is expecting the oil market to be in a deficit this year, which will, by the Committee’s estimate, peak at 2mm b/d in May 2021, according to reuters.com. This is in line with our maintained hypothesis that the producer coalition led by Saudi Arabia and Russia will continue to calibrate production in line with demand to keep global storage levels drawing. The JTC was not expected to recommend any change in production policy to oil ministers on Wednesday when they met. We expect OECD oil inventories to hit their rolling five-year average in 1H21, largely because of OPEC 2.0’s production discipline and production losses outside the coalition (Chart 8). Base Metals: Bullish Battery-grade lithium carbonate soared 40% y/y in January in China to $9,450/MT, according to mining.com. The reporting service noted strong demand for lithium iron phosphate (LFP) batteries used to power subsidized short-range autos, public transport infrastructure electrification, and power generation. Precious Metals: Bullish COVID-19-induced demand destruction pushed gold demand down 14% y/y in 2020, to just under 3,760 tons, according to the World Gold Council’s 2020 supply-demand tallies.  At 4,633 tons, gold supply lost 4% y/y, the most since 2013, according to the WGC.  Supplies were disrupted by COVID-19 as well.   (Chart 9). Ags/Softs: Neutral Despite poor weather conditions in South America, US farmers are beginning to worry about record or near-record crops in the current growing season, according to farmprogress.com. grains are trading lower following recent rallies on concerns the upcoming harvest could be better than expected. Tomorrow’s USDA WASDE report will be eagerly awaited for the Department’s latest assessments. Chart 8OPEC 2.0 Keeps Supply Growth Below Demand Growth OPEC 2.0 Keeps Supply Growth Below Demand Growth OPEC 2.0 Keeps Supply Growth Below Demand Growth Chart 9Gold Below 200 Day Moving Average Gold Below 200 Day Moving Average Gold Below 200 Day Moving Average     Footnotes 1     Our most recent reports on copper and oil prices – Copper's Supply Challenges and Brent Forecast: $63 This Year, $71 Next Year published 10 December 2020 and 21 January 2021 – highlight the tightening of industrial-commodity markets globally. 2     While we do find strong relationships between gold prices and 5- and 10-year US real rates, we do not find any relationship with the slope of the US rates forward curve. 3    For a discussion of equity risk premiums, please see Asness, Clifford S. (2000) “Stocks versus Bonds: Explaining the Equity Risk Premium.” Financial Analysts Journal. March/April 2000: pp. 96-113. 4    In the post-GFC period 2010-2020, the S&P 500 equity risk premium is borderline insignificant in a cointegrating regression that includes other real and financial variables (i.e., copper prices, US Fed Funds, and global economic policy uncertainty). We therefore to not treat it as determinant to the evolution of gold prices in the same way as the real and financial variables we use as regressors. 5    We expect this pandemic uncertainty to break, but not until markets are convinced sufficient supplies of vaccines will be available globally to control COVID-19 infections, hospitalizations and deaths. Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published last week, for further discussion. It is available at ces.bcaresearch.com. 6    For the first time 2011, the Prices Paid component in last month’s ISM Manufacturing PMI came in above 80, signaling for the first time since 2011. Please see No Tightening In 2021, published by BCA’s US Bond Strategy 2 February 2021. It is available at usbs.bcaresearch.com. 7     Please see Silver Likely Outperforms Gold In 2H20, which we published 2 July 2020. It is available at ces.bcaresearch.com. We recommended a long silver position then at $18.51/oz and closed it 23 September 2020 at $26/oz. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

In lieu of the next strategy report, I will be presenting the quarterly webcast titled ‘Five Contrarian Predictions For 2021-22’ on Thursday February 11 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join. Highlights Many of the ‘short squeezed’ investments that day traders have bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side. The biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. The happy corollary is that the structural bull market in equities will only end when the 10-year T-bond yield reaches zero. Until then, stay structurally overweight equities. Structurally overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal trade: short AUD/JPY. Feature Chart of the WeekShort-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) There is no divine law that decrees the ‘correct’ time-horizon for any investment. Depending on your objectives and skills, a correct investment horizon could be anything spanning a few milliseconds to a hundred years. Once you absorb this fundamental point, it leads to a profound conclusion:  The ‘correct’ price for any investment depends on your investment horizon. The Most Important Investment Question Is, Who Is Setting The Price? A long-term investor and a day trader will go through completely different thought processes to determine a stock’s ‘correct’ price. The long-term investor, intending to buy and hold the stock for ten years, will receive 40 quarterly dividend payments plus the stock price as it stands in 2031. Hence, the correct price is the discounted value of those expected cashflows. But for the day trader, intending to buy today to sell tomorrow, only one cashflow matters – tomorrow’s price. Hence, the correct price is simply the expected price at which he can sell tomorrow. The longer-term cashflows are irrelevant, unless they set the selling price tomorrow. Yet this is unlikely, because as Benjamin Graham put it:   In the long run the market is a weighing machine, but in the short run it is a voting machine. Therefore, a long-term investor and a day trader are completely different animals, whose price-setting behaviour must be seen through different lenses. This matters because the price is always set by the last marginal transaction. The important question then is, who is setting the price? All of which brings us to the battle raging between a cabal of day traders and a group of hedge funds. The day trader is buying today because he expects that the hedge fund, desperate to cover its short positions, must buy at an even higher price tomorrow. The day trader’s behaviour is rational, so long as it is within the law, and so long as the hedge fund short-covering is the marginal price taker. Eventually though, the desperate hedge fund will not take the price, because there are no more short positions left to cover. At this point, if the day trader wants to exit his position, the marginal buyer will be a longer-term investor who will only buy at a much lower fundamentally-determined price. The day trader will have won the battle, but lost the war. The crucial takeaway is that we should always monitor which time-horizon of investors is setting the marginal price of an investment. We can do this by continually measuring the fractal structure of the investment’s price. We should always monitor which time-horizon of investors is setting the marginal price of an investment. When the fractal structure of an investment has collapsed, it means that the time-horizon of investors setting the price has compressed to a near-term limit. Thereby it signals that the price-setting baton will return to long-term investors who will reset the price to valuation anchors, such as discounted long-term cashflows. The implication is that the preceding trend, fuelled by short-term price setters, is likely to reverse. Today, we observe that many of the investments that day traders have recently bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side (Chart of the Week, Chart I-2 and Chart I-3). Chart I-2Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Chart I-3Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) The Major Misunderstanding About Real Bond Yields A common question we get is, should we compare the prospective returns on equities and bonds in nominal terms or in real terms? In an apples-for-apples comparison it shouldn’t really matter. The problem is that while we know the prospective nominal return from bonds (it is just the bond yield), it is extremely difficult to know the prospective real return from bonds. As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield. A trustworthy ex-ante real bond yield requires a trustworthy prediction of inflation. But both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds are lousy at predicting inflation.1 As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield (Chart I-4 and Chart I-5). Chart I-4The Markets Are Lousy At Predicting Inflation In Europe... The Markets Are Lousy At Predicting Inflation In Europe... The Markets Are Lousy At Predicting Inflation In Europe... Chart I-5...And In The ##br##US ...And In The US ...And In The US A second point is that the required excess return on equities versus bonds is a nominal concept. This is because the bond yield’s lower limit is set in nominal terms, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. As the riskiness of equities and bonds converges, the required nominal return on equities collapses towards the ultra-low nominal bond yield. There are two important takeaways. First, we should always compare the valuation of equities and their prospective nominal return with the nominal bond yield. Second, the valuation of equities is exponentially sensitive to an ultra-low nominal bond yield (Chart I-6). Chart I-6The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential We conclude that the biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. Yet the happy corollary is that the structural bull market in equities will only end when bond yields can go no lower. In practice, this means when the 10-year T-bond yield reaches zero. Until then, long-term investors should stay in the stock market. The Major Misunderstanding About Valuation Another common question we get is, is it always meaningful to compare an investment’s valuation versus its own history? The answer is no. The comparison with a historical average is meaningful only if the valuation is mathematically stationary, which is to say it has not undergone a ‘phase-shift’. If the valuation has undergone a phase-shift, then the comparison with its own history is meaningless.  As an analogy, nobody would compare their bodyweight with its lifetime average, because we understand that our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our bodyweight with its lifetime average, it would give the false signal that we were permanently overweight! Likewise, to avoid getting a false signal from a valuation, we should always ask, has it undergone a phase-shift? If a valuation has undergone a phase-shift, then a comparison with its own history is meaningless. Unfortunately, the structural prospects for financials, oil and gas, and basic resources – sectors that dominate ‘value’ indexes and stock markets – did suffer a major downward phase-shift at the start of the 2000s (Chart I-7). It follows that we cannot compare the valuations of ‘value heavy’ indexes with their long-term history, and draw any meaningful conclusions. Chart I-7Value' Sector Profits Are In A Major Structural Downturn Value' Sector Profits Are In A Major Structural Downturn Value' Sector Profits Are In A Major Structural Downturn Proving this point, the relationship between value-heavy European valuations and subsequent 10-year return is much worse for periods ending after the global financial crisis compared with periods ending before it. Whereas the relationship between growth-heavy US valuations and subsequent return has barely changed, because the structural prospects for growth sectors have not suffered downward phase-shifts (Chart I-8 and Chart I-9). Chart I-8The Relationship Between Valuation And Future Return Has Changed In Europe... The Relationship Between Valuation And Future Return Has Changed In Europe... The Relationship Between Valuation And Future Return Has Changed In Europe... Chart I-9...But Not So Much ##br##In The US ...But Not So Much In The US ...But Not So Much In The US Given the ongoing trends in value versus growth profits, it is much safer to overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal Trading System* The rally in AUD/JPY is at a potential a near-term top based on its collapsed 65-day fractal structure. Accordingly, this week’s recommended trade is short AUD/JPY, setting the profit target and symmetrical stop-loss at 2.8 percent. Chart I-10AUD/JPY AUD/JPY AUD/JPY In other trades, short European basic resources versus the market achieved its 4 percent profit target and is now closed. The rolling 12-month win ratio now stands at 57 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Chart 1Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up There’s no doubt that inflationary pressures are building in the US economy. The latest piece of evidence is January’s ISM Manufacturing PMI which saw the Prices Paid component jump above 80 for the first time since 2011 (Chart 1). Large fiscal stimulus is clearly leading to bottlenecks in certain industries that were not negatively impacted by the pandemic, and this could cause consumer price inflation to rise during the next few months. However, the Fed will not view a spike in inflation as sustainable unless it is accompanied by a labor market that is close to maximum employment. The Fed estimates that “maximum employment” corresponds to an unemployment rate of 3.5% to 4.5%, and we calculate that average monthly payroll growth of about +500k is required to reach that target by the end of the year. The bottom line is that rising inflation will not lead to Fed tightening this year. We continue to expect liftoff in late-2022 or the first half of 2023. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 3 basis points in January. The index option-adjusted spread widened 1 bp on the month, leaving it 4 bps above its pre-COVID low. As discussed in last week’s report, the combination of above-trend economic growth and accommodative monetary policy means that the runway for spread product outperformance remains long.1 However, given that investment grade corporate bond spreads are extremely tight, investors should look to other spread products when possible. One valuation measure, the investment grade corporate index’s 12-month breakeven spread – with the index re-weighted to maintain a constant credit rating distribution over time – is down to its 4th percentile (Chart 2). This means that the breakeven spread has only been tighter 4% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 4% of the time (panel 3). While we don’t anticipate material underperformance versus Treasuries, we see better value outside of the investment grade corporate space. Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means that we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors pick up the additional spread offered by high-yield corporates, particularly the Ba credit tier where spreads remain wide compared to average historical levels (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* No Tightening In 2021 No Tightening In 2021 Table 3BCorporate Sector Risk Vs. Reward* No Tightening In 2021 No Tightening In 2021 High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in January. The average index option-adjusted spread widened 2 bps on the month, leaving it 47 bps above its pre-COVID low. Ba-rated credits outperformed duration-matched Treasuries by 50 bps on the month, besting B-rated bonds which outperformed by only 33 bps. The Caa-rated credit tier delivered 157 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only six defaults occurred in December, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in January. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened sharply in January, despite a continued rapid pace of refinancing activity (Chart 4). The option-adjusted spread adjusted downward in January and it now sits at 25 bps (panel 3). This is considerably below the 61 bps offered by Aa-rated corporate bonds and the 45 bps offered by Agency CMBS. It is only slightly above the 20 bps offered by Aaa-rated consumer ABS. The primary mortgage spread has tightened dramatically during the past few months (bottom panel), a key reason why refinancing activity has been so strong despite the back-up in Treasury yields. With the mortgage spread now closer to typical levels, it stands to reason that further increases in Treasury yields will be matched by higher mortgage rates. As such, mortgage refinancing activity could be close to its peak. While a drop in refinancing activity would be a reason to get more bullish on MBS, we aren’t yet ready to pull that trigger. The gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2), and we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service recently showed that a considerable majority of households will remain current on their loans once the forbearance period expires, causing the delinquency rate to fall back down.3 Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 24 basis points in January (Chart 5). Sovereign debt and Foreign Agencies underperformed duration-equivalent Treasuries by 21 bps and 7 bps, respectively, in January. Local Authority bonds outperformed the Treasury benchmark by 140 bps while Domestic Agency bonds and Supranationals outperformed by 15 bps and 7 bps, respectively. Last week’s report contains a detailed look at valuation for USD-denominated EM Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina.   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 108 basis points in January (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year and 6-8 year maturity buckets offer an after-tax yield pick-up versus Credit for investors with effective tax rates above 3% and 16%, respectively. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 21% and 33%, respectively.    All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in last week’s report. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in January. The 2/10 Treasury slope steepened 20 bps to 100 bps. The 5/30 Treasury slope steepened 13 bps to 142 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and stimulative fiscal policy will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on a duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels.       TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in January. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 14 bps and 1 bp on the month. They currently sit at 2.15% and 2.06%, respectively. Core CPI rose 0.09% in December, causing the year-over-year rate to dip from 1.65% to 1.61%. Meanwhile, 12-month trimmed mean CPI ticked up from 2.09% to 2.10%, widening the gap between trimmed mean and core (Chart 8). We expect 12-month core inflation to jump during the next few months, narrowing the gap between core and trimmed mean. As such, we remain overweight TIPS versus nominal Treasuries, even though the 10-year TIPS breakeven inflation rate looks expensive on our Adaptive Expectations Model (panel 2).5 We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in January. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps in January, while non-Aaa issues outperformed by 48 bps (Chart 9). The stimulus from the CARES act led to a significant increase in household income when individual checks were mailed out last April. Since then, households have used this stimulus to build up a considerable buffer of excess savings (panel 4). The large stock of household savings means that the collateral quality of consumer ABS is very high, and this situation won’t change any time soon with even more fiscal stimulus on the way. Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 75 basis points in January. Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in January, while non-Aaa issues outperformed by 185 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The average index spread tightened 4 bps on the month to reach 45 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 86 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 86 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) No Tightening In 2021 No Tightening In 2021 Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 29th, 2021) No Tightening In 2021 No Tightening In 2021 Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The dollar bounce has further to run. The DXY index could touch 94 before working off oversold conditions. In this environment, yen long positions also provide an attractive hedge. Meanwhile, Japan has stepped back into deflation, with the resurgence in Covid-19 cases constraining activity and consumption spending. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. Remain strategically short USD/JPY. Tactical investors can also short EUR/JPY as a trade. Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. We were stopped out of our long silver/short gold position last week. Reinstate. Feature The powerful bounce in global markets from the March lows is morphing into a speculative frenzy. The highlight this week centered on a few stocks, such as GameStop, Blackberry, and AMC Entertainment holdings, that have entered a manic phase. While liquidity conditions remain extremely favorable for risk assets, only a small shift in market sentiment may be required to trigger a reversal. The big risk from a technical perspective is that this reversal might be deeper and longer than most expect, given extremely overbought conditions. The dollar has tended to strengthen as market volatility rises. 2020 saw the rapid accumulation of dollar shorts, as low interest rates squeezed investors into more speculative assets, such as cryptocurrencies (Chart I-1). With these assets now having  jumped high into the stratosphere, and dollar-short positioning at a bearish nadir, the nascent bounce in the USD could morph into something bigger. In our report a fortnight ago,1 we argued for a 2%-4% rise, putting 94 on the DXY index within striking distance. Chart I-1Some Signs Of Speculative Froth Some Signs Of Speculative Froth Some Signs Of Speculative Froth Chart I-2The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The yen also generally benefits from rising volatility (Chart I-2). Should a market correction develop, it will provide the necessary catalyst for established long yen positions. Meanwhile, as we argue below, the backdrop in Japan is becoming more deflationary, which is also yen bullish. We are already short USD/JPY in our portfolio and recommend going short EUR/JPY for a trade. The Yen And Global Markets The AUD/JPY rate is extremely sensitive to equity market conditions (Chart I-3). Therefore, one of the ways to play a potential reversal in equity markets and a rise in volatility is to short the AUD/JPY cross. While we certainly recommend this trade tactically, we prefer to express this view via a short EUR/JPY position. There are three main reasons for this.  First, despite a significant rally in AUD/JPY, speculators are still very short the cross, as we showed two weeks ago. This is because short USD positions have been expressed in a concentrated number of currencies, including the euro. In a nutshell, speculators are very long EUR/USD and just neutral EUR/JPY (Chart I-4). This favors EUR short positions from a contrarian perspective, compared to AUD. Chart I-3The Yen And Equity Markets The Yen And Equity Markets The Yen And Equity Markets Chart I-4Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Second, Australia is doing much better in terms of containing the spread of Covid-19, compared to Europe as we argued last week.2 Australian export volumes and prices continue to recover smartly, and the basic balance remains in a healthy surplus. Meanwhile, there is a rising risk that the Covid-19 crisis will hit Europe particularly hard in Q1 this year. Interest rate markets are already beginning to discount this view. Real interest rates in the euro area are collapsing relative to Japan (Chart I-5). This will limit any fixed-income flows into the euro area from Japanese investors. At the margin, this is negative EUR/JPY. Third, given the most recent stimulus out of Europe, the European Central Bank’s (ECB) balance sheet is expanding faster than that of the Bank of Japan (BoJ). This has historically been negative for the EUR/JPY (Chart I-6). Chart I-5EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates Chart I-6EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets In a nutshell, equity markets are due for a healthy reset. In a similar fashion, a washing out of stale euro long positions will ensure the bull market for 2021 unfolds with higher conviction. Tactical investors can also short EUR/JPY as a trade. Outright short EUR/USD positions also make sense in the near term.  The Yen And Japanese Growth Japan has re-entered a debt-deflation spiral, and it is unclear how it will exit this predicament, other than via a rebound in external demand. While it remains our base case that external demand will recover, the yen will be held hostage in the interim to short-term safe-haven inflows, as real rates remain well bid. Like most other economies, Japan is seeing the worst private-sector contraction in decades. For an economy that has held interest rates near zero since the better part of the 90s, this is not good news. Whenever the structural growth rate of the Japanese economy has fallen below interest rates, the trade-weighted yen has staged a powerful rally (Chart I-7). A strong yen, on the back of deficient domestic demand, then leads to a self-fulfilling deflationary spiral. Chart I-7The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The latest Bank of Japan (BoJ) meeting was a clear indication that the central bank was out of policy bullets (the central bank left policy largely unchanged). The BoJ began to acknowledge this problem with the end of the Heisei era3 two years ago. A policy review is due in March of this year, but with aggressive stimulus in place since governor Haruhiko Kuroda took helm almost a decade ago, it is difficult to see how any changes could steer Japan out of deflation and towards a 2% inflation target anytime soon.  For example, with the BoJ owning 47% of outstanding JGBs, about 80% of ETFs and almost 5% of JREITs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. As a result, the impulse of the BoJ’s balance sheet could soon begin to fade, especially relative to that of other central banks (Chart I-8). Chart I-8The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon 2% Inflation = Mission Impossible? Most developed economies have not been able to meet their inflation targets over the last decade. While this might change going forward with unprecedented monetary and fiscal stimulus, it will not happen anytime soon. For example, the US is a much more closed economy than Japan and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream in the near future. Strictly looking at the data, the situation is even worse, with Japan having categorically stepped back into deflation (Chart I-9). The three key variables the authorities pay attention to for inflation – Core CPI, the GDP deflator, and the output gap – are all negative or rolling over. In fact, since the financial crisis, prices in Japan have only been able to really rise after a tax hike. Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and aging) population, leading to deficient demand (Chart I-10). Chart I-9Japan Is Back In Deflation Japan Is Back In Deflation Japan Is Back In Deflation Chart I-10Japan Prices And Demographics Japan Prices And Demographics Japan Prices And Demographics This view is corroborated in the inflation swap market. 5, 10, and 20-year inflation swaps in Japan are all depressed (Chart I-11). More importantly, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ or demographics, as it is by globalization. Chart I-11Is 2 Percent Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Fiscal Policy To The Rescue? Chart I-12Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Most governments have carte blanche on fiscal stimulus. While it is certainly the case that the Japanese government could boost spending via transfer payments, much of this income is more likely to be saved than spent by the private sector. In other words, the savings ratio for workers continues to surge. If consumers were not willing to spend prior to COVID-19,4 they are unlikely to do so under much more uncertain future conditions (Chart I-12). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity, or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. The first is a potential postponement of the Olympics once again for 2021. This will continue to be a drag on Japanese construction activity. Second, the Covid-19 pandemic has severely curtailed tourism in Japan, especially as Niseko and Hakuba, important ski destinations for foreigners, lose inbound momentum. Tourism makes up a non-negligible component of Japanese income. Finally, the labor (and income) dividend from immigration has practically vanished. The Yen Beyond The Near Term Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and the above factors could meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-13). Chart I-13The Yen And Relative Interest Rates The Yen And Relative Interest Rates The Yen And Relative Interest Rates Chart I-14DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together A continued rise in global equity markets is a key risk to our scenario. This will especially favor short dollar positions. However, as a low-beta currency, our contention is that the yen will surely weaken at its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-14). While short EUR/JPY positions will suffer, short USD/JPY bets should still fare well. As such, we remain strategically short USD/JPY. It is rare to find such a “heads I win, tails I do not lose too much” proposition. Housekeeping We were stopped out of our long silver/short gold position for a modest profit of 6%. We have profitably traded silver for almost two years now, and could see a speculative breakout in the metal over the next few months. We recommend reinstating this trade today with the ratio at 71, while maintaining our target at 65 and setting the stop loss at 72.5. We were also stopped out of our long petrocurrency basket versus the euro. With heightened volatility in oil prices, we will be looking to re-establish this trade from lower levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange and Global Fixed Income Strategy report, "Australia: Regime Change For Bond Yields And Currency," dated January 20, 2021. 3 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito, from January 8, 1989 until his abdication on April 30, 2019. 4 Ricardian equivalence suggests in simple terms that public-sector dissaving will encourage private-sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart I-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been resilient: US manufacturing activity continues to outperform its peers, with a solid 59.1 print on the Markit PMI for January. The S&P CoreLogic house price index grew by 9.5% year-on-year in November. Consumer confidence remains resilient, with the expectations component surging for the month of January. 4Q GDP came in at an annualized 4% quarter-on-quarter, in line with expectations. The DXY index was flat this week. The latest FOMC meeting reinforced the view that there will be no rush to tighten US monetary policy. Two preconditions for tightening is inflation well above 2% and tight labor market conditions. This suggests the path for least resistance for the US dollar is down, albeit with some near-term consolidation. Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart I-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart I-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area are softening: Manufacturing PMIs are rolling over, with the aggregate index down to 54.7 in January from 55.2. The German IFO Business climate index also softened from 92.1 to 90.1 in January. GfK consumer confidence slipped from -7.3 to -15.6 in February. The euro fell by 0.3% against the US dollar this week. As the broad dollar continues to work off oversold conditions, the euro remains a potent valve to allow for this reset. We are shorting EUR/JPY this week to profit from any setback in risk assets.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart I-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart I-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been disappointing: Departmental store sales fell by 13.7% year-on-year in December. Retail sales are softening overall in Japan. Tokyo CPI will be released overnight and is expected to stay weak. The Japanese yen fell by 0.7% against the US dollar this week. Our highest conviction call over the next one to three months is to be long the yen both versus the dollar and versus the euro. As we discuss in the front section of this report, short USD/JPY is an attractive “heads I win, tails I do not lose too much” bet. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart I-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart I-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been softening: The Markit manufacturing PMI fell from 57.5 to 52.9 in January. 88K jobs were lost in the three months ending November. This pushed up the ILO unemployment rate to 5%. Average weekly earnings rose by 3.6% year-on-year in November. The British pound was flat against the US dollar this week. Post-Brexit relations and Covid-19 vaccinations continue to dominate the news flow in Britain. The latter is progressing, but a difficult adjustment remains for Britain’s exporters. This will add volatility to the pound. We remain short EUR/GBP on valuation grounds.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart I-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart I-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been improving: CPI went up a notch in the fourth quarter, to 0.9% from 0.7%. The weighted median number was more encouraging at 1.4% NAB Business conditions improved from 9 to 14 in December. However, the expectations component deteriorated from 12 to 4. 4Q export prices rose by 5.5% quarter-on-quarter. The Australian dollar fell by 0.9% against the US dollar this week. The Aussie has been consolidating gains for most of January. The dominant feature driving the Aussie in the near term will continue to be terms of trade. We expect the AUD to resume its uptrend after a brief consolidation phase. We shied from implementing a short AUD/JPY trade today, preferring to express this view via short EUR/JPY. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart I-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart I-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week:  The trade surplus in 2020 was NZ$2.9bn, compared to a deficit of NZ$4.5bn in 2019.  The New Zealand dollar fell by 0.4% against the US dollar this week. Agricultural prices are consolidating after a rebounding from the lows of last year. Poor weather continues to be a worry on the supply side, but this is already reflected in very long Ag positioning. More should continue to deflate air off the high-flying kiwi. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart I-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart I-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada continues to disappoint: Building permits fell by 4.1% month-on-month in December. The Canadian dollar plunged by 1.3% against the US dollar this week. Oil prices are consolidating this year’s gains, which has weighed on the loonie. There is also the issue of the cancelled keystone XL pipeline, which is adding a risk premium for Canadian crude. We are short CAD/NOK as a trade, to capitalize on the latter headwind. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart I-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart I-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: The Swiss franc fell by 0.3% against the US dollar this week. The Swiss national bank (SNB) has two headaches to contend with in the coming weeks: a potential correction in the euro, which encourages safe-haven flows into the franc, and the lagged effects on a strong currency on domestic prices. This will force the hand of the SNB to continue being foreign exchange reserves at an aggressive pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart I-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart I-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate came down in November to 5% from 5.2%. The Norwegian krone fell by 2% this week on oil-related losses. Despite this, good management of the COVID-19 situation remains a positive catalyst relative to US or European peers. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart I-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart I-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has been mixed: The unemployment rate ticked up in December from 8.3% to 8.7%. Retail sales fell by 0.6% year-on-year in December, after rising by 5.7% the previous month. The trade balance improved from SEK1.4bn to SEK2.7bn in December. The Swedish krona fell by 0.8% against the US dollar this week. As a high beta currency, the Swedish krona typically bears the brunt of a US dollar rally. However, this time around, valuations provide a sufficient margin of safety for investors that are long. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Japan: Money And Asset Prices Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices Korea: Money And Asset Prices Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System February 2021 February 2021 The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… February 2021 February 2021 Chart II-2B…Account For Most Of The Surge In Deposits February 2021 February 2021   But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… February 2021 February 2021 Chart II-3B…Helped Facilitate More Money Creation Last Year February 2021 February 2021   Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Money Growth Used To Predict Economic Activity... Money Growth Used To Predict Economic Activity... Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Velocity Seemingly Predicts Inflation Over The Short-Term... Velocity Seemingly Predicts Inflation Over The Short-Term... Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output February 2021 February 2021   The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth   Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices   Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% February 2021 February 2021 The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues Chinas Economic Recovery Continues Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese Stocks: Which Way Will The Winds Blow? Chinese Stocks: Which Way Will The Winds Blow? Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Too Much Growth Priced In Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns