Inflation/Deflation

Highlights Historically, soft-budget constraints have typically been followed by periods of poor equity market performance. Soft-budget constraints could produce two distinct economic scenarios: malinvestment or inflation. Both are negative for equity investors. Odds are that the US will continue to pursue easy money policies, sowing the seeds of US equity underperformance in the years ahead. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints, which will weigh on their growth in the near term. However, forced restructuring could boost efficiency and productivity leading to their equity and currency outperformance in the coming years. Unlike other developing economies, China is not currently facing hard-budget constraints. However, the structural overhang from the past 10 years of soft-budget constraints is lingering on and in some cases is increasing. The Thesis The consensus in the investment industry is that cheap money and ample stimulus are good for share prices. We do not disagree with this thesis when it is applied to the near and medium-term equity strategy. However, excessive stimulus and easy money policies — we refer to these as soft-budget constraints — bode ill for share prices in the long run. The investment relevance of this thesis is as follows. Since March, the US has implemented the largest fiscal and central bank stimulus in the world and will likely continue doing so in the coming years (Chart I-1). Such soft-budget constraints will likely support the US economy for now. Nevertheless, they will also sow seeds of future US equity underperformance and currency depreciation. Conversely, many emerging economies (excluding China) have failed to provide sufficient fiscal and credit support to their economies (Chart I-2). The resulting hard-budget constraints will foreshadow their economic underperformance vis-à-vis the US in the coming months. Chart I-1Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Chart I-2EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints   That said, hard-budget constraints will force companies in these EM economies into deleveraging, restructuring and improving efficiency. Ultimately, such hard-budget constraints will benefit EM shareholders in the long run. This thesis has been a key rationale behind our decision to close the short EM / long S&P 500 strategy on July 30, and to turn negative on the US dollar on July 9. In the months ahead, we will be looking for an opportunity to upgrade EM equities to overweight versus the S&P500. BOX 1 Gauging Budget Constraints In our opinion, the best way to gauge budget constraints for the real economy is by monitoring changes in the money supply. This is due to the following reasons: First, net changes in the money supply account for all net loan origination. Second, the money supply also reflects the monetization of public and private debt by the central bank and commercial banks. When a central bank and commercial banks acquire a security from or lend to a non-bank entity, they create new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not change the stock of money supply. We have deliberated on these topics at length in past reports. Securities transactions among non-banks do not create new or destroy existing deposits, i.e., they have no impact on the money supply. Rather, these constitute an exchange of securities and existing deposits between sellers and buyers. Provided these types of transactions do not expand the money supply, they do not, according to our framework, alter budget constraints. Finally, the broad money supply, not central bank assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Commercial banks’ excess reserves at the central bank – a large item on the central bank balance sheet - do not constitute a part of the broad money supply. Empirical Evidence The following are examples of soft-budget constraints that were followed by periods of weakening productivity growth, diminishing return on capital and poor equity market performance: 1. China’s soft budget constraints in 2009-10 Due to the post-Lehman crisis stimulus, the change in broad money exploded above 40% of GDP (Chart I-3, top panel). The economy boomed from early 2009 until early 2011 as cheap and abundant money super-charged investment and consumption. Chart I-3China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance However, Chinese share prices — the MSCI China Investable equity index excluding technology, media and telecom (TMT)  — peaked in H1 2011 in absolute terms (Chart I-3, second panel). Relative to the global equity index excluding TMT, the Chinese investable stocks index began underperforming in late 2010 (Chart I-3, third panel). The basis for this equity underperformance was falling return on assets for non-financial companies due to capital misallocation, breeding inefficiencies and diminishing productivity gains (Chart I-3, bottom two panels). In China, the excessive stimulus of 2009 and 2010 and ensuing recurring rounds of soft-budget constraints put a floor under the economy but have destroyed shareholder value. 2. Money overflow in EM ex-China in 2009-10. China’s boom in 2009-10 produced a bonanza for other emerging economies. Not only Chinese imports from developing economies boosted the latter’s balance of payments and income but also international investors rushed into EM equity and fixed income. EM companies and banks took advantage of easy financing and their international borrowing skyrocketed. Finally, EM policy makers stimulated and domestic bank credit boomed. This period of soft-budget constraints led to complacency, lower productivity, falling return on capital and/or inflation in the following years (Chart I-4). Their financial markets performance in the 10 years that followed the soft-budget constraints in 2009-10 has been dismal. The share price index of EM ex-China, Korea and Taiwan as well as the total return on their currencies (including the carry) versus the US dollar have been in a bear market (Chart I-4, bottom two panels). 3. The credit and equity bubbles in Japan, Korea and Taiwan of the late 1980s Money and credit bubbles proliferated in Japan, Korea and Taiwan in the late 1980s (Chart I-5, Chart I-6 and Chart I-7).  Chart I-4EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market Chart I-5Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-6Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-7Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth   Their productivity growth rolled over in the late 1980s amid easy money policies. Share prices deflated in Japan, Korea and Taiwan in the 1990s (please refer to the middle and bottom panels of Charts I-5, I-6 and I-7). Chart I-8ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise 4. The boom-bust cycle in emerging Asia ex-China in the 1990s Soft-budget constraints prevailed in many emerging Asian economies in the first half of the 1990s. Foreign money inflows and domestic bank credit produced an economic boom. The consequences of such soft-budget constraints were debt-financed malinvestment, falling return on assets and massive current account deficits (Chart I-8). All of these culminated in epic currency and banking crises. 5. The credit bubbles in the US and Europe leading to the 2008 crash Lax credit standards propelled credit and property booms in the US and Southern Europe in the period of 2002-2007. Broad money ballooned in the euro area and swelled in the US (please refer to Chart I-1 on page 2). These property bubbles unraveled in 2007-08. These are well known, and we will not delve into the details. Soft-Budget Constraints Lead To Malinvestment Or Inflation Soft-budget constraints could produce two distinctive economic scenarios – malinvestment or inflation. Both are negative for equity investors. The malinvestment scenario occurs when easy money propels undisciplined capital spending. Easy and abundant money boosts medium-term growth and, thereby, creates the illusion of an economic miracle. The latter renders companies, creditors, investors and government officials complacent. Creditors lend a lot and do so based on optimistic assumptions while companies expand hastily and invest carelessly. The result is capital misallocation, i.e., companies pour money into projects that do not ultimately produce sufficient cash flow. Equity investors project high growth expectations into the future and bid up share prices. Government officials preside over an unsustainable growth trajectory overlooking lurking systemic risks and deteriorating economic fundamentals. Easy money and unlimited financing typically bode ill for efficiency and productivity— this is simply due to human nature. Companies neglect efficiency considerations and, as a result, productivity stagnates. Consequently, cost overruns and unprofitable investments suffocate corporate profits. Declining corporate earnings at a time of expanded capital base culminate in a collapse of return on capital. This is the crucial reason why share prices drop. As profits and return on capital decline, companies retrench by cutting costs and halting investment spending. Defaults mushroom, leading creditors to cut new financing. The inflation scenario transpires when easy money boosts consumption more than investment. Easy money and unlimited financing lift household income and consumption. This can arise from a large fiscal stimulus or private sector's borrowing and spending. On the one hand, robust household income growth inevitably leads to higher wage growth expectations. On the other hand, limited investment brings about productivity stagnation. Mounting wages and languishing productivity growth lead to rising unit labor costs and, ultimately, result in a corporate profit margin squeeze. Faced with corporate profit margin shrinkage, companies either raise prices, i.e., pass through higher costs, or retrench by shedding labor and shrinking capital spending even further. The latter produces a widespread economic downturn, and stifles business profits and share prices. A symptom of higher inflation is a wider current account deficit. With an economy’s productive capacity lagging behind demand, the gap between the two can be filled in by imports. In addition, escalating domestic costs make a country less competitive, which inhibits exports and bloats imports. When a central bank is unwilling to tighten monetary policy meaningfully amid high and rising inflation and/or a widening current account deficit, it falls behind the inflation curve. This constitutes a very bearish backdrop for the exchange rate. Currency depreciation erodes the country’s equity returns in common currency terms versus other bourses. Can an economy with soft-budget constraints, i.e., booming money growth, avoid both malinvestment and inflation? Yes, it can if it is able to boost productivity growth so that it avoids systemic capital misallocation (i.e., investments produce reasonable returns to pay off to creditors and shareholders) and escapes higher inflation by expanding output faster to meet growing demand. However, achieving higher productivity growth amid soft-budget constraints is easier said than done. Bottom Line: The scenario of malinvestment has been playing out in China since 2009. Capital misallocation also occurred in the US and parts of Europe during the 2002-2007 credit boom, and took place in Japan, Korea and Taiwan in the late 1980s. Malinvestment, with some elements of inflation, occurred in emerging Asian countries prior the 1997-98 crises as well as in many EM economies like India, Indonesia and Brazil in 2009-2012. Investment Implications It is fair to say that the unprecedented economic downturn in the US warranted an exceptionally large stimulus. The question for the next several months and years is whether US authorities will: overstay easy policies and make soft-budget constraints a permanent feature of the US economy, or tighten policy earlier than warranted, or navigate policy perfectly so that the economy is neither too hot nor too cold. Our sense is that US authorities will overstay their easy money policies. If the US continues to pursue macro policies in the form of soft-budget constraints, will the nation experience malinvestment or inflation? Our sense is that the US will likely experience asset bubbles and inflation. As the Federal Reserve stays behind the inflation curve in the coming years, the US dollar will be in a multi-year downtrend. Hence, the strategy should be selling the greenback into rebounds. We switched our short positions in select EM currencies— such as BRL, CLP, ZAR, TRY, KRW, IDR and PHP —away from the US dollar to an equal-weighted basket of the euro, CHF and JPY on July 9. For now, EM currencies will lag DM currencies. US equity outperformance versus the rest of the world is in the late innings (Chart I-9). The pillars of US equity underperformance in common currency terms will be excessive US equity valuations, a potential new era of US return on capital underperforming the rest of the world and greenback depreciation. Chart I-9US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages The top panel of Chart I-10 illustrates that the difference between US investors owning international stocks and non-US investors holdings of US equities is at a record low. This reveals that both US and foreign investors currently "over-own" US stocks versus non-US equities. Perfect timing of a structural trend reversal is impossible, but we believe US equity outperformance will discontinue before year-end. That was the rationale behind terminating our short EM / long S&P 500 strategy and upgrading EM equity allocation from underweight to neutral. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints which will weigh on their economic performance in the near term. This is why we are not rushing to upgrade EM stocks and currencies to overweight. However, the lack of cheap money will force these EM countries and their companies to do the right things: deleverage households and companies, clean up and recapitalize their banking systems and undertake corporate restructuring. Ultimately, hard-budget constraints will likely sow the seeds of high productivity and, with it, equity and currency outperformance in the years to come. China is a tricky case. On a positive note, it has not stimulated as much during the pandemic as it did in 2009. Besides, policymakers are now aware of the ills that come with soft-budget constraints and have been working hard to address these. Critically, the Chinese population, businesses and the authorities are all united in the nation’s confrontation with the US. Complacency in this context is not a major risk and the focus on efficiency and productivity will be razor sharp. On the negative side, the credit, money and property bubbles that had not been dealt with before the pandemic are now increasing with the stimulus. Continued malinvestment and falling return on capital in China’s old economy sectors is signified by the very poor performance of China’s cyclical “old economy” stocks (Chart I-11, top panel). In turn, bank share prices are making new cyclical lows underscoring their worsening structural outlook (Chart I-11, bottom panel). Chart I-10Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Chart I-11Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises   Weighing the pros and cons, we infer that the cyclical recovery in China has further to run. This will support China’s growth and equity outperformance for now. That is why we continue to recommend overweighting China within an EM equity portfolio. However, as the credit and fiscal impulses fade starting in H1 next year, structural malaises will resurface posing risks to China’s equity outperformance.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Portfolio Strategy Softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. A firming macro backdrop, the USD’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Recent Changes Downgrade the S&P hypermarkets index to underweight, today. This move also pushes our S&P consumer staples sector to a modest below benchmark allocation. Table 1 Lessons From The 1940s Lessons From The 1940s Feature In our March 23 Weekly Report, when we identified 20 reasons to start buying equities, we published a cycle-on-cycle profile (Chart 1, top panel) of how the SPX performs following a greater than 20% drawdown. History suggested that, on average, new all-time highs would emerge sometime in early 2022! Unfortunately, this assessment proved offside as the S&P 500 made fresh all-time closing highs last week, less than five months from the March 23 trough. Chart 1Overstretched Overstretched Overstretched Nevertheless, comparing the current unprecedented SPX rebound with the historical recessionary profile remains instructive as it highlights how excessively stretched equities currently appear. The bottom panel of Chart 1 warns that the SPX is vulnerable to a snapback, were the SPX to return to the historical mean or median recovery profile. Likely rising (geo)political risks could serve as a near-term catalyst for a healthy pullback. Importantly, all of the SPX’s return since the March lows is due to the multiple expansion and then some, as forward EPS have taken a beating (not shown). Equities are long duration assets and given the drubbing in the discount rate, the forward P/E multiple has done all the heavy lifting. Chart 2 puts some historical context to the S&P 500 forward P/E going back to 1979 using I/B/E/S data. Empirical data supports finance theory and shows that the 40-year bull market in bond prices has caused a structural upshift to the SPX forward P/E. Chart 2Moving In Opposite Directions Moving In Opposite Directions Moving In Opposite Directions While low rates explain the near all-time highs in the SPX forward P/E, looking ahead we doubt that the SPX multiple can expand much further if we assume that the easy assist from ZIRP is behind us and will not repeat; i.e. the Fed will refrain from wrecking the US banking system by exploring NIRP. In contrast, our analysis suggests that a selloff in the bond market is the missing ingredient that will ignite a massive rotation out of growth stocks and into value and propel deep cyclicals versus defensives to uncharted territory. More specifically, the rallies in copper prices, crude oil and the CRB Raw Industrials index need confirmation from the bond market that they are demand, rather than supply driven. This backdrop will also shift equity returns within deep cyclicals away from a handful of tech stocks and toward other beaten down high operating leverage sectors (i.e. energy, industrials and materials) as we posited in our recent August 3 Special Report “Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives”. Zooming out and observing how investors have moved capital from one asset class to the next in the aftermath of QE5 is in order (Chart 3). First, the SPX enjoyed a V-shaped recovery from the March 23 lows. Then in early-May, as we first posited in our May 11 Weekly Report, the big EURUSD up-move was set in motion and investors started piling into short USD positions taking cue from the Fed’s QE5 that was directly targeting the US dollar with liquidity swaps. The debasing of the dollar served as a global reflator. Now the final piece of the QE5 puzzle is the bond market. Chart 3 highlights that in order for QE to work, counterintuitively a selloff in the bond market would confirm that the economy is healing and is ready to start standing on its own two feet. The jury is still out. With regard to the Fed’s remaining bullets, yield curve control (YCC) is one unorthodox tool that the FOMC could choose to deploy in the coming years. On that front, turning back in time and drawing parallels with the 1940s is instructive. In 1942 the Fed, at the behest of the Treasury, pegged long-term interest rates at 2.5% and ballooned its balance sheet in order to finance the government’s expenditures during WWII. The Fed surrendered its independence, and this YCC unwarrantedly stayed in place until 1951 when in the midst of the Korean War, the Treasury-Federal Reserve Accord finally ended the peg of government long-dated bond interest rates.1 Chart 3Bonds Yields Are Left To Rally Bonds Yields Are Left To Rally Bonds Yields Are Left To Rally Chart 4WWII-Like Starting Point WWII-Like Starting Point WWII-Like Starting Point Chart 4 shows the ebbs and flows of the US government’s total debt-to-GDP ratio and fiscal deficit as a percentage of output since 1940. While the debt-to-GDP profile fell from 1945 onward owing partially to a tight fiscal ship that the US subsequently ran, it troughed when the US floated the greenback. Since then, the US has been fiscally irresponsible running large budget deficits and the debt-to-GDP ratio has never looked back and very recently went parabolic (top panel, Chart 4). Charts 5 & 6 take a closer look at some macro variables in the 1940s and Charts 7 &  8 compare them to today. Chart 5The… The… The… Chart 6…1940s… …1940s… …1940s… First, YCC did not prevent the late-1948 recession (Chart 5, shaded areas). Crudely put, monetary stimulus is not a panacea for boom/bust cycles. Second, M2 growth was climbing at a 30%/annum rate, the money multiplier was on a secular advance and money velocity was surging especially in the first half of the 1940s (Chart 6). As a result and as expected, YCC caused three significant inflationary jumps (bottom panel, Chart 6) that aided the US government in bringing down the massive debt-to-GDP ratio (i.e. inflating its way out of a debt trap) that it had accumulated via large deficits in the front half of the 1940s (top panel, Chart 5). Third, interest rates were a coiled spring and once the Treasury-Fed Accord was signed, they exploded higher (fourth panel, Chart 5). Finally, equities fared well during the first three years of YCC until the end of WWII, but then suffered an outsized setback until mid-1949, before recovering and taking out the 1945 highs in 1951 (bottom panel, Chart 5). Chart 7...Compared With… ...Compared With… ...Compared With… Chart 8…Today …Today …Today Were the Fed to embark on YCC in the near-future in order to monetize the US government’s deficits, there are a few parallels to draw with the 1940s especially given that the starting point of debt-to-GDP is similar to the WWII figure (top panel, Chart 4). The Fed would likely lose its independence. This would be a paradigm shift. The Fed would crowd out fixed income investors, and flood the market with US dollars. M2 money stock would continue to surge. Few investors will be chasing US dollar assets including equities. The path of least resistance would be significantly lower for the US dollar as foreign investors would flee. This debt monetization along with a depreciating currency and swelling money supply would result in inflation rearing its ugly head, especially given that import prices would soar. What is difficult to envision is how the economy would perform during an inflationary impulse. Our sense is that the risk of stagflation would rise significantly, especially given the current inverse correlation between M2 growth and the velocity of money.2 In the stagflationary 1970s, any liquidity injections via higher M2 growth failed to translate into rising money velocity. Importantly, the “Nixon shock” effectively ended the Bretton Woods system and floated the US dollar causing a 40% devaluation from peak-to-trough (Chart 9). Tack on the oil related supply shock and stagflation reigned supreme in the 1970s, owing to cost-push inflation. Chart 9Dollar The Reflator Dollar The Reflator Dollar The Reflator In contrast during the 1940s, demand-pull inflation hit the economy rather hard, as the US was retooling its industrial base to win WWII alongside its allies. Also the US dollar was linked to gold since the Gold Reserve Act of 1934 and ten years later the Bretton Woods international monetary agreement ushered in the era of fixed exchange rates, which is a big difference from the 1970s.3 As a reminder, from a political perspective venturing down the inflation avenue is the least painful way of dealing with a debt burden, rather than pursuing tight fiscal policy which is synonymous with political suicide. From an equity perspective, owning commodity-levered sectors and other hard asset-linked equities including REITs would make sense as we highlighted in our recent inflation Special Report. Health care stocks would also shine in case of an inflationary spurt according to empirical evidence that we highlighted in the same Special Report. On the flip side, our inflation Special Report also revealed that shedding telecom services and utilities would be wise and most importantly avoiding technology stocks. Tech stocks are disinflationary beneficiaries as they are mired in constant deflation and have built business models not only to withstand, but also to thrive in deflation. Inflation is a tech killer as these growth stocks suffer when the discount rate spikes and causes valuations to move from a premium to a discount. Nevertheless, deflation/disinflation is more likely in the coming 12-to-18 months, whereas inflation is at least two-to-three years away as we mentioned in our recent inflation Special Report. This week we continue to augment our cyclicals versus defensives portfolio bent and take our defensive exposure down a notch by downgrading consumer staples to a modest below benchmark allocation via a downgrade in the S&P hypermarkets index. Downgrade Hypermarkets To Underweight… Last summer we upgraded the S&P hypermarkets index to overweight as we were preparing the portfolio to withstand a recessionary shock given that the yield curve had inverted. Fast forward to the March carnage in the equity markets and this defensive move served our portfolio well. However, we did not want to overstay our welcome and set a stop in order to exit this position that was triggered in late-March netting our portfolio 26% in relative gains. More recently, we have been adding cyclical exposure to the portfolio and lightening up on defensives and as a continuation of this shift we are now compelled to downgrade the S&P hypermarkets to underweight. The economy is reopening and thus it no longer pays to seek refuge in safe haven hypermarket equities. In fact most of the macro indicators we track suggest the recession is over that will sustain severe downward pressure on relative share prices. Chart 10 shows that the ISM manufacturing new orders subcomponent has slingshot from below 30 to north of 60, junk spreads are probing all-time lows, consumer confidence has troughed and small and medium enterprises hiring intentions are on the mend. Moreover, the extraordinary fiscal expansion has brought spending forward and PCE is all but certain to skyrocket when the Q3 GDP figures get released in late-October, signaling that the easy money has been made in Big Box retailers (top panel, Chart 11). Similarly, discretionary spending should pick up the slack from staple-related purchases, further dampening the need to own hypermarket shares (middle & bottom panels, Chart 11). Chart 10Rebounding Macro Rebounding Macro Rebounding Macro Chart 11Returning to Normality Returning to Normality Returning to Normality On the operating front, while WMT is making strides in its online presence and offering mix, non-store retail sales are on a tear dominated by King AMZN (as a reminder we are overweight the S&P internet retail index). This is a secular trend and should continue unabated and in a relative sense continue to weigh on hypermarket profitability (bottom panel, Chart 12). Finally, a significant tailwind is turning into a severe headwind for this industry: import price inflation. The US dollar has reversed course and it is in a freefall. Historically, the greenback has been an excellent leading indicator of import price inflation and the current message is grim for hypermarket razor thin profit margins (import prices shown inverted, Chart 13). Chart 12Amazonification Is On Track Amazonification Is On Track Amazonification Is On Track Chart 13Currency Headwinds Currency Headwinds Currency Headwinds Adding it all up, softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. Bottom Line: Trim the S&P hypermarkets index to underweight. The ticker symbols for the stocks in this index are: BLBG S5HYPC – WMT, COST. …Which Pushes Consumer Staples To A Below Benchmark Allocation The downgrade in the S&P hypermarkets index tilts our S&P consumer staples sector to a modest below benchmark allocation. Countercyclical consumer staples stocks served their purpose and provided the support to our portfolio in the front half of the year when we needed them most. Now that the economic reopening is gaining steam and the government, the health care system and society are all ready to effectively deal with a flare up in the pandemic, the allure of defensive positioning has diminished. In other words, COVID-19 is currently a known known risk versus an unknown unknown risk early in the year, and defending against it now is more successful. Moreover, according to our mid-April research on what sectors investors should avoid during recessionary recoveries, consumer staples stocks trail the SPX on average by 660bps one year following the SPX trough. The current macro backdrop corroborates this analysis and underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also consumer confidence is making an effort to trough (ISM manufacturing and consumer confidence shown inverted, Chart 14). Meanwhile, financial market variables emit a similarly bearish signal for safe haven staples stocks. Following a brief spike in the bond-to-stock ratio (BSR), the BSR has recently resumed its downdraft (top panel, Chart 15). Volatility has all but collapsed since soaring to over 80 in March, as the Fed has orchestrated a quashing of all asset class volatilities (middle panel, Chart 15). Lastly, the pairwise correlation between stocks in the S&P 500 has also nosedived bringing some semblance of normality back into equity markets (bottom panel, Chart 15). All three of these financial market variables will continue to exert downward pressure on relative share prices. Chart 14V-shaped Recovery… V-shaped Recovery… V-shaped Recovery… Chart 15...Across The Board ...Across The Board ...Across The Board On the US dollar front, while consumer goods manufacturers get a P&L translation gain from a depreciating currency, their export exposure is on par with the SPX and does not provide a relative advantage. In marked contrast, empirical evidence shows that relative profitability moves in tandem with the greenback and the USD recent weakness will undercut consumer staples profitability (bottom panel, Chart 16), especially via climbing input cost inflation. In sum, a firming macro backdrop, the US dollar’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Bottom Line: Downgrade the S&P consumer staples index to underweight. Chart 16Mind the Gap Mind the Gap Mind the Gap Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background 2     The velocity of money “is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.” Source: Federal Reserve Bank of St. Louis. 3    Our colleagues from The Bank Credit Analyst recently illustrated how a strong dollar is good for the US economy on a medium term basis. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings ​​​​​​​ Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 ​​​​​​​Favor value over growth

Highlights Nominal Yields: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yields: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. US Economy: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Feature Chart 1Reflation Pushes Real Yields Lower Reflation Pushes Real Yields Lower Reflation Pushes Real Yields Lower Market movements during the past couple of months are consistent with an environment of economic reflation. Equities and commodity prices are up, the US dollar is down, spread product has outperformed Treasuries and TIPS breakeven inflation rates have widened. This “reflation trade” is the result of global economic recovery and highly accommodative Fed policy, the latter being particularly important. In fact, Fed policy has been so accommodative that bonds are the one asset class that has so far bucked the broader reflationary trend. Nominal Treasury yields dipped during the past few weeks, as rising inflation expectations were more than offset by plunging real yields (Chart 1). Our base case expectation is that, broadly speaking, the reflation trade will continue. Global economic growth will improve during the next 6-12 months and Fed policy will remain highly accommodative. In this week’s report we consider how to position for that outcome in US rates markets. In the process, we provide trade recommendations for the nominal, real and inflation compensation curves. We also consider the main risk to our reflationary view: The possibility that further US fiscal stimulus is too little or arrives too late. Positioning For Reflation Chart 2More Downside In Short-Maturity Real Yields More Downside In Short-Maturity Real Yields More Downside In Short-Maturity Real Yields Back in April, we explained how the Fed’s zero-lower-bound interest rate policy can lead to unusual movements in bond markets, particularly in how real bond yields respond to broader market trends.1  The importance of the zero lower bound is easily seen through the lens of the Fisher Equation – the equation that connects nominal yields, real yields and inflation expectations. Real Yield = Nominal Yield – Inflation Expectations If the Fed is expected to hold the nominal short rate steady for a long period of time, then nominal bond yields won’t move around very much in response to the economy. Necessarily, this means that increases in inflation expectations must be matched by falling real yields. Chart 1 shows how this has played out for 10-year yields, but the dynamic is even more pronounced at the short-end of the curve where the Fed has greater control over nominal rate expectations (Chart 2). With these relationships in mind, we consider the outlooks for the nominal, inflation compensation and real yield curves. Nominal Treasury Curve Chart 3Fed Guidance Has Crushed Nominal Rate Vol Fed Guidance Has Crushed Nominal Rate Vol Fed Guidance Has Crushed Nominal Rate Vol As is alluded to above, fed funds rate expectations drive nominal Treasury yields. Treasury yields rise when the market revises its rate expectations up and fall when the market revises its expectations down. But what happens when the Fed signals that the funds rate will stay pinned at its current level, even as inflationary pressures mount? What happens is that nominal bond yields become increasingly insensitive to fluctuations in economic data and rate volatility plunges (Chart 3). Not surprisingly, this decline in rate volatility has been more pronounced at the front-end of the curve than at the long-end (Chart 3, bottom panel). This is because the Fed’s rate guidance exerts more influence over short maturities. The market might be very confident that the fed funds rate will stay at its current level for the next year or two, but it will be less confident about rate expectations five or ten years down the road. The conclusion we draw is that the Fed’s dovish rate guidance will prevent a large increase in nominal bond yields, even as the reflation trade rolls on. But at some point, rising inflation expectations will cause the market to price-in policy firming at the long-end of the curve and long-maturity nominal Treasury yields will move somewhat higher. Historically, nominal bond yields usually move in the same direction as TIPS breakeven inflation rates (Chart 4). Chart 4Nominal Yields And Inflation Expectations Are Positively Correlated Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation While this base case outlook calls for flat-to-slightly higher Treasury yields, we recommend keeping portfolio duration close to benchmark on a 6-12 month investment horizon. The reason for this caution is that significant downside risks to our base case economic scenario remain (see section “Avoiding Deflation” below). Chart 5Bullets Trade Expensive When Rates Are Pinned At Zero Bullets Trade Expensive When Rates Are Pinned At Zero Bullets Trade Expensive When Rates Are Pinned At Zero Instead, we recommend positioning for the continuation of the reflation trade via duration-neutral yield curve steepeners. The nominal yield curve will respond to global economic recovery by steepening because the market will price-in eventual policy tightening at the long-end of the curve before it prices-in near-term policy tightening at the front-end of the curve. Specifically, we suggest buying the 5-year bullet and shorting a duration-neutral barbell consisting of the 2-year and 10-year notes. This trade is designed to profit from steepening of the 2/10 yield curve.2 The one problem with our proposed trade is that it is not cheap. The 5-year bullet yield is below the 2/10 barbell yield and the 5-year bullet trades as expensive on our yield curve model (Chart 5). However, we note that the 5-year looked much more expensive at the height of the last zero-lower-bound episode in 2012. In today’s similar environment, we anticipate a return to similar valuation levels. Bottom Line: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation Curve Chart 6Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model Almost by definition, the continuation of the reflation trade means that the cost of inflation compensation will rise (i.e. TIPS breakeven inflation rates will move higher), and we remain positioned for that outcome. However, at least according to our Adaptive Expectations Model, the inflation component of bond yields could have a more difficult time rising going forward. Our model, which is based on several different measures of realized inflation, shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value (Chart 6). In other words, further upside from here is contingent upon rising inflation. Fortunately, rising inflation seems likely during the next few months. Month-over-month headline CPI bottomed in April (Chart 7), the oil price is trending up (Chart 7, panel 2) and core inflation has undershot relative to the trimmed mean (Chart 7, panel 3). All of this suggests that our model’s fair value will move higher during the next few months. Chart 7Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed But beyond the near-term snapback that we anticipate, a wide output gap in the United States will prevent inflation from entering a sustainable uptrend as we head into 2021. After all, our Pipeline Inflation Indicator remains deep in deflationary territory (Chart 7, bottom panel).  At some point near the end of this year, we anticipate getting an opportunity to move tactically underweight TIPS versus nominal Treasuries, once breakevens start to look expensive on our model. Our Adaptive Expectations Model shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value. A higher conviction long-run trade relates to the slope of the inflation curve. At present, the 10-year CPI swap rate remains somewhat above the 2-year rate, but we eventually expect this slope to invert (Chart 8). With the Fed explicitly targeting a temporary overshoot of its 2% inflation target, it would make sense for the cost of short-maturity inflation protection to trade above the cost of long-maturity inflation protection. This would mark a significant break from historical trends, but this is also true of the Fed’s new policy approach. Chart 8Inflation Curve Will Invert Inflation Curve Will Invert Inflation Curve Will Invert Bottom Line: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yield Curve Chart 9Buy Real Yield Curve Steepeners Buy Real Yield Curve Steepeners Buy Real Yield Curve Steepeners At the beginning of this report we noted that the combination of stable nominal rate expectations and rising inflation expectations has led to a steep decline in real Treasury yields. This decline has been more severe at the short-end of the curve, which has resulted in real yield curve steepening (Chart 9). At the long-end of the curve, the outlook for the level of real yields is highly uncertain, even under the assumption that the reflation trade continues. If 10-year nominal rate expectations hold steady, then continued reflation will lead to a further decline in the 10-year real yield. However, as discussed above, long-dated nominal rate expectations will eventually follow inflation expectations higher. If that adjustment to long-dated rate expectations outpaces the increase in expected inflation compensation, then the 10-year real yield will move up as well. The outlook for the short-end of the curve is more certain. Two-year nominal rate expectations are unlikely to budge anytime soon. This means that the continuation of the reflation trade will send the cost of 2-year inflation protection higher and the 2-year real yield lower. For this reason, we would rather take a position in real yield curve steepeners than an outright position on the level of real yields. In fact, as long as the reflation trade continues, the real yield curve should steepen whether the absolute level of real yields is rising or falling. It is only in a renewed deflation scare where we would expect the real yield curve to flatten, as occurred back in March. As long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Bottom Line: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Avoiding Deflation The first part of this report talked about how to position in rates markets assuming that the global economic recovery remains on track and that the so-called reflation trade continues. While this is our base case scenario, it is by no means a certainty. In fact, this view is contingent upon continued US fiscal stimulus that is sufficient to sustain household income and prevent a snowballing of foreclosures and bankruptcies. March’s CARES act did a more-than-admirable job supporting household income. In fact, disposable household income rose 7.2% in the four month period between March and June compared to the four months that preceded the COVID recession (Chart 10). This is a far greater increase than what was seen in the first four months of the 2008 recession (dashed line in Chart 10, panel 2), despite the fact that the hit to wage compensation has been worse (dashed line in Chart 10, bottom panel). Chart 11A confirms that, without the CARES act, the hit to disposable income would have been substantial. Chart 10Income Well Supported... So Far Income Well Supported... So Far Income Well Supported... So Far Chart 11ADisposable Personal Income Growth And Its Drivers I Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation The problem is that the main income supporting provisions of the CARES act have either been paid out or have expired. Chart 11B shows the impact on disposable income of the CARES act’s different provisions. The two most important were: The Economic Impact Payments: The one-time $1200 stimulus checks. The Pandemic Unemployment Compensation Payments: The extra $600 per week that was added to unemployment benefits. Chart 11BDisposable Personal Income Growth And Its Drivers II Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation The Economic Impact Payments have all been delivered, and the Pandemic Unemployment Compensation Payments expired at the end of July. Based on the information that has been released about the ongoing negotiations over a follow-up stimulus bill, we expect that a compromise deal will be large enough to keep disposable income at or above pre-recession levels.3 However, a compromise is proving difficult. Congress’ foot dragging prompted President Trump to announce several executive orders of questionable legality in an attempt to deliver some stimulus. However, even if the executive orders are followed, the boost to household income will be meager without another bill. The President’s executive order to extend the extra unemployment benefits appropriates only $44 billion from the Disaster Relief Fund and asks states to contribute the rest. Many states will be unable to contribute anything, and an extra $44 billion amounts to only 8% of the income support provided by the CARES act. State & local government aid must be addressed in the new stimulus bill. The other urgent area that must be addressed in a follow-up stimulus bill is aid for state & local governments. State & local government spending fell 5.6% (annualized) in the second quarter, as governments have been forced to impose harsh austerity in the face of collapsing tax revenues (Chart 12). This is one area where the Democrats and Republicans are still far apart. The Center on Budget and Policy Priorities estimates that states need $555 billion to close COVID-related budget shortfalls.4 The Democrats’ initial proposal contained $1.13 trillion for states, the Republicans’ initial offer left out state & local government aid altogether. Chart 12State & Local Governments Need A Bailout State & Local Governments Need A Bailout State & Local Governments Need A Bailout Bottom Line: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Based on the numbers that have been floated, that deal will contain sufficient income support to keep households afloat and the recovery on track. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 To understand why this trade profits in an environment of yield curve steepening please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 In their initial proposals, House Democrats offered $435 billion in Economic Impact Payments and $437 billion for expanded unemployment benefits. The Senate Republicans offered $300 billion for Economic Impact Payments and $110 billion for expanded unemployment benefits. For context, the CARES act authorized $293 billion for Economic Impact Payments and $268 billion for expanded unemployment benefits. For more details on the ongoing budget negotiations please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War”, dated July 31, 2020, available at gps.bcaresearch.com 4 https://www.cbpp.org/research/state-budget-and-tax/states-continue-to-face-large-shortfalls-due-to-covid-19-effects   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week A Massive Shock To Growth ... And Interest Rates A Massive Shock To Growth ... And Interest Rates Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Table 2Global Spread Products In Our Analysis Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, There will be no Weekly Report on August 10, as the US Equity Strategy team will be on vacation for the week. Our regular publication schedule will resume on Monday August 17, 2020 with a Special Report by my colleague Chester Ntonifor, BCA’s Chief FX Strategist on the interplay of the style bias and the US Dollar. We trust that you will find this Report both informative and insightful. Kind Regards, Anastasios Feature Before getting to our analysis on why cyclicals will best defensives, we want to address our definition of cyclicals and defensives, where we think tech stands and why, discuss what our current positioning is and what time horizon we are targeting for this portfolio bent. Cyclicals And Defensives Definition Table 1 is a stripped down version of our current recommendations table and shows that our cyclicals definition is one of deep cyclicals including industrials, materials, energy and the information technology sector. Utilities, consumer staples, health care and telecom services (which is currently categorized as a GICS2) comprise our defensives universe. Table 1US Equity Strategy's Cyclicals Vs. Defensives Current Recommendations Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives Tech Is Still Cyclical Importantly, we still consider the tech sector a deep cyclical and not a safe haven sector. While the COVID-19 fallout has acted as an accelerant especially to a faster absorption of goods and services of the tech titans, that is not a de facto change in the behavior of these still cyclical stocks.  As a reminder tech stocks have 60% export exposure or 20 percentage points higher than the broad market. The implication is that US tech trends should follow the ebbs and flows of the global economy. Contrary to popular belief that technology equities behaved defensively recently, empirical evidence gives credence to our hypothesis that technology stocks remain cyclical: from the Feb 19 SPX peak until the March trough the IT sector underperformed all four defensive sectors (Chart of the Week). In marked contrast, tech has left in the dust defensive sectors since the March bottom, cementing its cyclical status. Chart of the WeekTech Remains A Cyclical Sector Tech Remains A Cyclical Sector Tech Remains A Cyclical Sector Current Positioning With regard to our broader technology positioning, we are currently neutral the S&P tech sector, overweight the S&P internet retail index (which Amazon dominates) that sits under the S&P consumer discretionary sector and underweight the S&P interactive media & services index (which includes Alphabet and Facebook) that falls under the newly formed S&P communications services sector. Thus, our broadly defined tech sector exposure remains neutral. Meanwhile, last week we boosted the S&P materials sector to overweight and that move pushed our cyclicals/defensives bent marginally to preferring deep cyclicals to defensives (please see market cap weights in Table 1). Timing Is Key This portfolio bent may run into some near-term trouble as we expect a flare up of (geo)political risks (please see here and here), but once the election uncertainty lifts, hopefully in late-November/early-December, from that point onward and on a 9-12 month time horizon cyclicals should really start to flex their muscles versus defensives.  The purpose of this Special Report is to identify the top ten drivers of the looming cyclicals versus defensives outperformance phase on a cyclical time horizon. What follows is one page one chart per key reason, in no particular order of importance. 1.)    Dollar The Reflator Time and again we have highlighted the boost that internationally exposed sectors get from a weakening greenback. Cyclicals are the primary beneficiaries of such a backdrop as a lot of these deep cyclical companies garner over 50% of their sales from abroad. We recently updated in a Special Report the breakdown of GICS1 sectors’ foreign sourced revenues and more importantly their performance during US dollar bear markets. Cyclicals clearly have the upper hand. Chart 1 shows this tight inverse correlation, irrespective of what USD index we use. Finally, looking ahead a falling greenback will act as a relative profit reflator (US dollar shown inverted, bottom panel, Chart 1), especially given that most of the defensive sectors are landlocked in the US and do not get a P&L fillip from positive translation gains. Chart 1CHART 1 CHART 1 CHART 1 2.)    Global Growth Recovery Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel, Chart 2). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel, Chart 2). Tack on the meteoric rise in the G10 economic surprise index (third panel, Chart 2) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel, Chart 2). Chart 2CHART 2 CHART 2 CHART 2 3.)    US Capex To The Rescue The latest GDP report made for grim reading. US capex collapsed 27% last quarter in line with the fall it suffered in Q1/2009. Not even bulletproof software investment escaped unscathed and contracted for the first time in seven years, albeit modestly. However, if the looming recovery resembles the GFC episode when real non-residential investment soared 40 percentage points from that nadir in the subsequent five quarters, then a slingshot rebound will ensue by the end of 2021. Importantly, our US capex indicator has an excellent track record in leading the relative share price ratio and confirms that a capex trough is already in store, tracing out the bottom hit during the Great Recession (top panel, Chart 3). Regional Fed surveys also signal that a capex boom looms in the coming quarters (middle panel, Chart 3). And, so do cheery CEOs that expect a sizable investment recovery in the next six months, according to the Conference Board survey (bottom panel, Chart 3). All of this is a harbinger of a cyclicals outperformance phase at the expense of defensives. Chart 3CHART 3 CHART 3 CHART 3 4.)   Chinese Capex On The Upswing (Fiscal Easing) Across the pacific, Chinese excavator sales have gone vertical. While we take Chinese data with a grain of salt, Komatsu hydraulic excavator demand growth in China has averaged 45% on a year-over-year basis in the quarter ending in June. This Japanese company’s data, which has been unaffected by the US/Sino trade war, corroborates the Chinese official statistics (top panel, Chart 4). Infrastructure spending is also on the rise in China following an abrupt halt in projects started early in 2020. This revving of the investment spending engine is bullish for the broad commodity complex including US cyclicals (bottom panel, Chart 4). Chart 4CHART 4 CHART 4 CHART 4 5.) Chinese Monetary Easing None of the above investment recovery would have been possible had the Chinese authorities not opened up the liquidity spigots. Monetary easing via the sinking reserve-requirement-ratio (RRR) has been instrumental in engineering an economic rebound (RRR shown inverted, third panel, Chart 5). The credit-easing channel has been also important in funneling cash toward investment, and the climbing Li Keqiang index is evidence that sloshing liquidity is being put to good use (bottom & second panels, Chart 5). Finally, Chinese loan demand data also confirms that an economic recovery is in the offing and heralds a US cyclicals versus defensives portfolio tilt (top panel, Chart 5).  Chart 5CHART 5 CHART 5 CHART 5 6.)   Firming Financial Market Data (Chinese And EM Equity Market Outperformance) Typically, financial market data are early in sniffing out a turn in economic data. This anticipatory nature of financial markets is currently signaling that EM in general and Chinese economic growth in particular will make a significant comeback in the coming quarters. Importantly, Chinese bourses and the MSCI EM equity index (in USD) have recently started to outperform the ACWI and the SPX (Chart 6). Both of these equity markets are more cyclically exposed than the defensive US and global indexes because of the respective sector composition and have paved the way for a sustainable rise in the US cyclicals/defensives share price ratio (Chart 6).   Chart 6CHART 6 CHART 6 CHART 6 7.)    Transition From Deflation To Inflation Similarly to the EM and Chinese equity market outperformance of their DM peers, commodity prices are putting in a bottom and forecasting a brighter global trade backdrop for the rest of the year (top panel, Chart 7). The depreciating US dollar is also underpinning the commodity complex and this should serve as a catalyst for an exit from the recent global disinflationary backdrop, especially corporate wholesale price deflation. Domestically, the prices paid subcomponent of the ISM manufacturing survey is firming and projecting that relative pricing power will favor cyclicals versus defensives (bottom panel, Chart 7). Chart 7CHART 7 CHART 7 CHART 7 8.)   Profit Expectations Have Turned The Corner Sell-side extreme pessimism has given way to mild optimism as depicted by the now positive relative Net Earnings Revisions (NER) ratio (third panel, Chart 8).  Importantly, despite the spike in the relative NER ratio, the bar has not risen enough both on a relative profit growth and revenue growth basis in order to short circuit the recovery in the relative share price ratio (second & bottom panels, Chart 8).  Chart 8CHART 8 CHART 8 CHART 8 9.)   Alluring Valuations The relative Valuation Indicator remains below the neutral zone offering a cushion to investors that are contending to execute a cyclicals versus defensives portfolio bent (Chart 9).   Chart 9CHART 9 CHART 9 CHART 9 10.) Enticing Technicals Lastly, cyclicals are still unloved compared with defensives as our relative Technical Indicator (TI) highlights in Chart 10.  In fact, our relative TI also hovers below the neutral zone, near a level that has marked previous playable recovery rallies (bottom panel, Chart 10). Chart 10CHART 10 CHART 10 CHART 10     But Monitor Three Key Risks Over the coming 12 to 18 months, investors should prepare their portfolios for an outperformance phase of cyclical sectors relative to defensives. Nonetheless, we are closely monitoring a number of key risks that can put our view offside. First, the relentless rise of ex-Vice President Biden in the polls on PREDICTIT, the rapidly increasing probability of a “Blue Sweep” in the upcoming elections, and the non-negligible risk of a contested election (as discussed in a joined Special Report with our sister Geopolitical Strategy service last week), all pose a short-term threat to the benign election backdrop priced into stocks. Were a risk-off phase to materialize in the next three months, as we expect, then cyclicals would take the back seat versus defensives, at least temporarily (bottom panel, Chart 11). Second, what worries us most is that Dr. Copper and crude oil (another global growth barometer), especially compared with gold, have yet to confirm the global growth recovery. In other words, the fleeting oil-to-gold and copper-to-gold ratios underscore that the liquidity-to-growth handoff has gone on hiatus. While we are not ready to throw in the towel yet, these relative commodity signals are disconcerting, and were they to deteriorate further, they would definitely undermine our optimistic view on global growth (top and second panels, Chart 11). Finally, it is disquieting that our relative profit growth models have no pulse. They represent a significant risk to the relative earnings-led rebound which the rest of the indicators we track are anticipating (third panel, Chart 11). Chart 11Three Key Risks We Are Monitoring Three Key Risks We Are Monitoring Three Key Risks We Are Monitoring Bottom Line: On balance, a looming global growth recovery and pending global capex upcycle, a softening US dollar, commodity price inflation and Chinese monetary easing will more than offset the trifecta of rising election-related risks, the current unresponsiveness of our relative profit growth models and the lack of confirmation of a liquidity-to-growth transition. This will pave the way for a cyclicals outperformance phase at the expense of defensives.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com  

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US Helicopter' Money in the US Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: 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 consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap EM Currencies Are Cheap EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Monetary Policy: Central bankers worldwide are promising to keeping policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, tolerating a rise in inflation just as many of the secular forces that have dampened global inflation are fading. Bond Strategy: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy. Feature “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” – Fed Chairman Jerome Powell Central bankers have emptied their bags of tricks in recent months, providing extreme monetary policy accommodation to fight the deflationary impacts of the COVID-19 recession. 0% policy interest rates, large-scale asset purchases and liquidity support programs have all been implemented in some form by the major developed market central banks. Even more extreme options like yield curve control have been contemplated in the US and implemented in Australia. Perhaps the most important tool used by policymakers, however, is the most simple of all – dovish forward guidance on future interest rate moves. The Fed, European Central Bank (ECB), Bank of Japan (BoJ) and others are now committing to keep rates at current levels for at least the next two years. Additional “state-based” guidance, tying future rate hikes only to a sustainable return of inflation back to policymaker targets, is the likely next step, with the Bank of Canada already making that connection at last week’s policy meeting. Given how difficult it has been for central banks to reach those targets, policy rates can now potentially stay lower for much longer. Interest rate markets have already discounted such an outcome, with overnight index swap (OIS) curves pricing in no change in policy rates in the US, Europe, UK, Japan, Canada or Australia until at least mid-2022 and only very mild increases afterward (Chart of the Week). It remains to be seen if policymakers will actually follow through on their promises to sit on their hands and do nothing for that long, even as global growth and inflation continue what will likely be an extended and choppy recovery from the deep COVID-19 recession. Chart of the WeekAggressive Forward Guidance Is Working Can Central Bankers Credibly Be Not Credible? Can Central Bankers Credibly Be Not Credible? However, if central bankers are truly serious about keeping interest rates low even if inflation picks up, in an attempt to “catch up” from previous undershoots of inflation targets, that has major implications for global bond investors – in particular, raising the value of maintaining core holdings of inflation-linked bonds in fixed-income portfolios. The First Step To Higher Inflation: Stop Talking About Rate Hikes Central bankers are increasingly using the same arguments, and even the same language, to justify their current hyper-accommodative policy stance. Here are some examples, taken from speeches and policy meetings that took place last week: ECB President Christine Lagarde: “We expect interest rates to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon and such convergence has been consistently reflected in underlying inflation dynamics.” Federal Reserve Governor Lael Brainard: “Looking ahead, it likely will be appropriate to shift the focus of monetary policy from stabilization to accommodation by supporting a full recovery in employment and a sustained return of inflation to its 2 percent objective […] policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence.” Bank of Canada Governor Tiff Macklem: "As the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support. The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.” Chart 2Global Growth Expectations Have Rebounded Global Growth Expectations Have Rebounded Global Growth Expectations Have Rebounded We could have switched the names on those three quotes and the message would be the same. Policy rates will stay at current levels until inflation has sustainably returned to the 2% target. Raising rates on the back of a forecast of higher inflation, driven by an expectation of lower unemployment, will not be enough this time for policymakers that have been repeatedly burned by their belief in the Phillips Curve. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. The latest data from the ZEW survey of economic and financial market sentiment, that was published last week and covers the period to mid-July, shows this shift in expectations. On the economy, the current conditions indices for the euro area, US, UK and Japan have stopped falling, while the expectations data have all soared to the highest levels seen since 2015 (Chart 2). The ZEW also poses questions on expectations for interest rates and inflation, and there the answers are more interesting for bond investors. The net balances on expectations for long-term interest rates have bottomed out for the US, euro area and UK, as have expectations for inflation over the next twelve months (Chart 3). At the same time, expectations for short-term interest rates have lagged the moves seen in the other two series, with the net balances hovering around zero for all four countries. One possible interpretation of this data is that a greater number of the financial professionals who take part in the ZEW survey are starting to “get the hint” about central bankers’ dovish messages, expecting higher inflation and bond yields but with no change in short-term policy rates. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. We see similar pricing in inflation-linked bond markets. While nominal bond yields have stayed stable, the mix between inflation expectations and real bond yields has shifted. Breakevens on 10-year bonds have been slowly climbing across the major developed markets since the end of March, while real yields have fallen roughly the same amount as breakevens have widened (Chart 4). Chart 3Global Inflation Expectations Are Drifting Higher Global Inflation Expectations Are Drifting Higher Global Inflation Expectations Are Drifting Higher Chart 4Inflation Breakevens & Real Yields: Mirror Images Inflation Breakevens & Real Yields: Mirror Images Inflation Breakevens & Real Yields: Mirror Images This is a relatively unusual development in the global inflation-linked bond universe. More often, breakevens and real yields move in the same direction. Inflation expectations tend to rise when economic growth is improving, which also puts upward pressure on real bond yields – often in tandem with markets pricing in higher policy rates at the short end of yield curves. That is not the case today. The latest fall in real bond yields may simply be markets pricing in slower potential economic growth, and lower equilibrium real interest rates, in a world where the COVID-19 pandemic is likely to leave lasting scars. That would be consistent with Bloomberg growth and inflation forecasts for the major developed economies, which expect unemployment rates to remain above pre-COVID levels in 2022, with inflation rates struggling to reach 2% (Chart 5). Chart 5The Consensus Expects A Slow Global Recovery Can Central Bankers Credibly Be Not Credible? Can Central Bankers Credibly Be Not Credible? In a recent report, we presented some basic Taylor Rule estimates of the “appropriate” level of policy rates for the US, euro area, UK, Japan, Canada and Australia after the collapse in growth seen in response to the COVID-19 lockdowns. We used the most basic formulation of the Taylor Rule that put equal weight on deviations of headline inflation from central bank target levels, and deviations of unemployment from full-employment NAIRU measures. Chart 6Taylor Rules Suggest Rates Will Need To Head Higher Can Central Bankers Credibly Be Not Credible? Can Central Bankers Credibly Be Not Credible? Given the surge in unemployment and collapse in inflation due to the COVID-19 recession, Taylor Rule estimates were calling for negative nominal interest rates across the developed economies (Chart 6). The estimates were most severe in the US, where a fed funds rate of -3.8% is deemed “appropriate” with an unemployment rate of 11% and headline CPI inflation at 0.6%. When the Bloomberg consensus forecasts for the next two years are put into the Taylor Rule, a rising path for interest rates is projected but with rates remaining below pre-COVID levels. However, if policymakers stick to their current pledge to keep rates on hold for longer to ensure that inflation not only returns to 2%, but also stays there without the help from very easy monetary policy, then the implication is that a “below-appropriate” interest rate will be maintained for an extended period. Interest rate markets have already come to that conclusion. 5-year OIS rates, 5-years forward are trading between 0% and 1% across the developed economies – levels that are below the neutral interest rate estimates we are using in our Taylor Rule forecasts (Chart 7). Chart 7Markets Priced For An Extended Period Of Below-Neutral Rates Markets Priced For An Extended Period Of Below-Neutral Rates Markets Priced For An Extended Period Of Below-Neutral Rates With interest rates already at or near the zero bound, any rise in inflation from current levels also near 0% will result in real policy rates turning negative if central banks do nothing. This would be consistent with the messages sent by the ZEW survey, and global inflation linked bond markets where real yields are falling deeper into negative territory. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility. This is especially true for the likes of the Fed, which has a well-established history of turning hawkish at the first sign of rising inflation pressures. The Fed has already hinted that it is considering shifting its policy strategy to allow overshoots of inflation after periods of undershooting the 2% target. Other central banks, like the ECB, have announced similar reviews of their inflation targets and strategy. Such a move to tolerate higher levels of inflation is a logical response to a global pandemic and deep global recession, coming on the heels of several years of low inflation. The timing may actually be ideal to run more dovish policies to boost inflation, with many of the structural factors that have helped restrain global inflation starting to turn in a more inflationary direction. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility.  Bottom Line: Central bankers worldwide are promising to keep policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, becoming more tolerant of faster inflation. Potential Reasons Why Inflation Could Return Central bankers are talking a good game right now, pledging not to turn too hawkish, too soon and allowing inflation to move back above policy targets. It remains to be seen if they would actually follow through and do nothing if realized inflation rates were to start climbing back to 2% or even higher. It is unlikely that policymakers will be facing that choice anytime soon. The COVID-19 pandemic is showing no signs of slowing in the US and large emerging market countries, global growth remains fragile and heavily reliant on monetary and fiscal policy support, and inflation rates worldwide are currently closer to 0% than 2%. Yet at the same time, there are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. Demographics Chart 8Demographics Have Turned Less Disinflationary Demographics Have Turned Less Disinflationary Demographics Have Turned Less Disinflationary BCA Research Global Investment Strategy has noted that the global demographic trends that helped restrain inflation in recent decades are shifting.1 The ratio of the number of global workers to the number of global consumers – the global support ratio - peaked back in 2013 and is now steadily falling (Chart 8). There are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. A rising support ratio implies there are more people producing through work than consuming which, on the margin, is disinflationary. Now, with baby boomers leaving the labor force in droves and becoming consumers in retirement (especially consuming services like health care), the support ratio is falling and becoming a potentially more inflationary force. Globalization Chart 9Globalization Has Turned Less Disinflationary Globalization Has Turned Less Disinflationary Globalization Has Turned Less Disinflationary One of the biggest disinflationary forces of the past quarter-century has been the rapid increase in global trade. As trade barriers fell and global supply chains expanded, companies were able to lower their costs of production. This allowed companies to widen profit margins without resorting to large price increases, helping to dampen overall inflation rates. Now, with global populism and protectionism on the rise, trade as a share of global GDP is declining (Chart 9). The COVID-19 pandemic will likely exacerbate this trend as more companies bring production closer to home, reversing the disinflationary impact of global supply chains, on the margin. A Strong US Dollar The relentless rise of the US dollar in recent years has exerted a major disinflationary headwind to the world economy, with a large share of global traded goods and commodities priced in dollars. Now, with the greenback finally showing signs of rolling over on a more sustainable basis (Chart 10), fueled by less favorable interest rate differentials and signs of improving global growth, the dollar is slowly becoming a more inflationary force. Chart 10USD Weakness Would Be Inflationary USD Weakness Would Be Inflationary USD Weakness Would Be Inflationary Chart 11Structural Reasons Why Policy Rates Need To Stay Low Structural Reasons Why Policy Rates Need To Stay Low Structural Reasons Why Policy Rates Need To Stay Low Of course, these factors are slow moving and will not necessarily result in an immediate increase in global inflation. Yet the trends now in place are more inflationary, on the margin, than has been the case for many years. Coming at a time when global productivity growth is anemic, the potential for an inflationary spark from overly easy monetary policies should not be ignored. Especially given the very high levels of private and public debt in the developed world, which puts more pressure on policymakers to choose inflation as a way to reduce debt burdens (Chart 11).   Investment Implication – Stay Overweight Inflation-Linked Bonds Central bankers are now signaling a desire to keep interest rates lower for longer, both to provide stimulus for virus-stricken economies and to boost weak inflation. Coming at a time when secular disinflationary forces are losing potency, this raises the risk of a protracted period of negative real policy rates as inflation rises and policymakers do little to stop it pre-emptively. Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Chart 12Maintain A Core Overweight In Inflation-Linked Bonds Maintain A Core Overweight In Inflation-Linked Bonds Maintain A Core Overweight In Inflation-Linked Bonds Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Inflation breakevens are more likely to creep upward than soar higher in the near term given the lingering economic threat from the COVID-19 pandemic. Yet inflation-linked bonds are likely to outperform nominal government debt over the next few years – if central bankers stay true to their word and keep rates unchanged while welcoming a pickup in inflation. The experience of the years following the 2008 financial crisis, when global policy rates were kept near 0% and central banks expanded balance sheets through quantitative easing, may be a template to follow. Global inflation linked bonds, as an asset class, steadily outperformed nominal government bonds from 2012-2016, shown in Chart 12 on a rolling 3-year annualized basis using benchmark indices from Bloomberg Barclays. A similar extended period of outperformance is not out of the question over the next few years, with central banks ramping up asset purchases once again and promising to keep policy easy until inflation returns. Bottom Line: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy where our models show that breakevens are most undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Investment Strategy "Third Quarter 2020 Strategy Outlook, Navigating The Second Wave", dated June 30, 2020, available at gis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Can Central Bankers Credibly Be Not Credible? Can Central Bankers Credibly Be Not Credible? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The yield advantage behind the dollar bull market since 2011 has completely evaporated. This has unhinged one of the final pillars of dollar support.  However, there is also a shifting paradigm in currency markets as nominal rates have hit zero –  the highest real rates can now be found in defensive currencies, where deflation is more pervasive. Most cyclical currencies are still sporting very negative real rates. In such a world, the most appropriate strategy is a barbell – overweighting the cheapest currencies, like the NOK and SEK, along with some defensives like the JPY. Trades at the crosses also make sense. We added a long CAD/NZD trade to our basket last week. Stick with it. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than a short DXY position. Feature Chart I-1Our Trading Model Is Bearish The Dollar Our Trading Model Is Bearish The Dollar Our Trading Model Is Bearish The Dollar Trading the foreign exchange markets can be complex and very humbling. That said, there are still some simple strategies that have consistently delivered excess returns over time. Regular readers of our bulletin are familiar with our framework based on three main vectors: the macroeconomic environment, valuation, and sentiment. Over time, a three-factor model based on these vectors has outperformed a buy-and-hold strategy for the majority of developed market currency pairs (Chart I-1).1 Within the model, an equal weight is assigned to all three factors, but the reality is that the most important variable to figure out is what the macro landscape will look like over a cyclical horizon. More often than not, the macro framework rather than valuation or sentiment is more important in timing turning points in currency markets. Over time, this can be a very potent source of alpha. Currencies, Inflation, And Real Rates Our starting point for figuring out the macro  environment is to go back to the four-quadrant chart splitting inflation and growth with the performance of currencies (Chart I-2). Two key observations stand out: Early on in any cycle, the dollar depreciates across most currencies. This is when growth is improving but inflation is still weak, allowing for very easy global monetary settings. As the cycle matures and deflationary pressures set in, a bullish dollar strategy is an absolute winner. In between an upcycle and a downturn, the performance of the dollar is more ambiguous. Trades at the crosses tend to do well in this environment. Chart I-2The Dollar, Fed, And Business Cycles A Simple Framework For Currencies A Simple Framework For Currencies The next step is to figure out which environment are we in today. An upturn is typically characterized by easy monetary settings and improving growth but weak inflation. This ensures the monetary impulse for growth remains at full throttle. The US dollar declines in this environment because the growth impulse is usually higher elsewhere, since the US has a lower manufacturing base. Early on in any cycle, the dollar depreciates across most currencies.  One way to figure out if we are early in the cycle is from the bond market. Early in the cycle, the cost of capital is well below the return on capital. This is the case for the US, where the NY Fed’s neutral rate estimate is well above the fed funds rate. Unsurprisingly, this correlates quite well with the yield curve, suggesting borrowing to invest makes sense. In the same vein, most economic leading indicators are perking up (Chart I-3). Given that inflation is not a problem today, the next key driver for currencies will be what happens to real growth. The yield advantage behind the dollar bull market since 2011 has completely evaporated. However, there is also a shifting paradigm in currency markets as nominal rates have hit zero – the highest real rates are now being found in defensive currencies (Chart I-4). For that to change, real rates have to rise in cyclical markets. The evidence so far is encouraging: Chart I-3Cost Of Capital Is Less Than Return On Capital Cost Of Capital Is Less Than Return On Capital Cost Of Capital Is Less Than Return On Capital Chart I-4Higher Real Rates In Switzerland And Japan A Simple Framework For Currencies A Simple Framework For Currencies   Relative PMIs outside the US are picking up faster than within the US (Chart I-5). In the euro zone, the improvement in the expectations component of the surveys are pointing to a very significant recovery in the PMIs in the months ahead (Chart I-6). China is stimulating aggressively. This is very potent fuel for domestic demand as well as global trade (Chart I-7).   Chart I-5Growth Is Outperforming Outside The US Growth Is Outperforming Outside The US Growth Is Outperforming Outside The US Chart I-6Eurozone Green Shoots Eurozone Green Shoots Eurozone Green Shoots Chart I-7China Green Shoots China Green Shoots China Green Shoots A pickup in real growth outside the US should improve bond yields in cyclical economies, encouraging flows into their capital markets. As we posited last week, an important component of these flows will also be into their equity markets, making the value-versus-growth debate very important for currencies.2 Coming back to our model, the main input into the macroeconomic component is real interest rate differentials. From this lens, the message so far is to remain long defensive currencies like the Swiss franc and Japanese yen that have the highest real rates. Measuring Value Chart I-8US Dollar Is Overvalued A Simple Framework For Currencies A Simple Framework For Currencies The macroeconomic component is only one of three factors – valuation and sentiment being equally important. Over the years, our team has compiled a swath of valuation models, which we follow quite closely. For the purposes of a simple framework, we stuck to purchasing power parity (PPP) when building out the valuation component. PPP is a very poor tool for managing currencies over the short term, but an excellent one at extremes. We have enhanced the computation to adjust for a few roadblocks that have proved crucial in adding value. Consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, an adjustment is necessary. This includes creating a synthetic price basket that looks at a very similar basket of goods and services across countries. If, for example, shelter is 33% in the US CPI basket but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, British pound, and Norwegian krone.  The results show the US dollar as overvalued, especially versus the Swedish krona, British pound, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc (Chart I-8). Using this valuation framework, long-term returns have been compelling. The bottom line is that while most cyclical currencies are still sporting very negative real rates, some are very undervalued from a cyclical perspective. This suggests the discount already accounts for negative real rates. Timing The Turning Point Turning points in foreign exchange markets tend to be most visible via capital flows. This makes the sentiment component of our model quite important. The nascent upturn in a few growth indicators is coinciding with an outperformance of value relative to growth and cyclicals versus defensive stocks. As we mentioned last week, it is an important signal to watch for currencies. Three ratios hold the key in determining when the dollar capitulates: The total return of US bonds versus gold, the USD/CNY exchange rate, and the gold-to-silver ratio (GSR). The  rationale for the three is as follows: As the Fed continues to increase the supply of bonds, the ratio of the US bond ETF (TLT)-to-gold (GLD) will be an important proxy for investor sentiment on the dollar. One of the functions of money is as a store of value, and gold remains a viable threat to dollar liabilities. Foreigners already have been stampeding out of US bond markets. A falling ratio will suggest domestic private investors are dumping their holdings in exchange for precious metals (Chart I-9). As geopolitical tensions between the US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, the USD/CNY is depreciating, suggesting dollar liquidity is providing a blanket cover over other ancillary issues. Finally, the gold-to-silver ratio correlates well with the dollar. Gold does well when there is financial stress in the system, forcing the Fed to undermine the value of the dollar through massive dollar supply injections. Silver does well when entities take advantage of cheap dollar funding to finance higher-return projects. It is a timely indicator about the liquidity-to-growth transmission mechanism (Chart I-10). Importantly, the new economy, technology, and clean energy industries are significant  buyers of silver . These industries are also cheaper outside the US, as we posited last week. Chart I-9Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Chart I-10Watch The Gold-To-Silver Ratio Watch The Gold-To-Silver Ratio Watch The Gold-To-Silver Ratio In short, the huge directional indicator for the dollar bear market will be a crash in the GSR. This will act as both confirmation that the dollar bear market is full-fledged and that the tug-of-war between growth and liquidity is over. We have been highlighting this trade in recent months as one of our high-conviction calls. The sentiment component of our FX trading model uses a more traditional approach. As a momentum currency, signals like death crosses or bombed-out rates of change are potent. With the dollar in freefall, the signal is to keep selling. While it is true that speculators are already short, they were also long during most of the dollar bull market from 2011. Housekeeping Our currency strategy remains the barbell – overweighting the cheapest currencies like the NOK and SEK, along with some defensives like the JPY. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than an outright short DXY position. Our FX model, highlighted on the first page, suggests this will be the case. We have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. The macro landscape remains fraught with uncertainties, so we have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. Being long petrocurrencies versus the euro is also a nice carry trade. Finally, we were stopped out of our long cable position this week for a small profit of 2.4%. GBP has been one of our favorite contrarian trades, having booked 9.6% profits being long versus the yen last year. Volatility brings opportunity, and we will look to reestablish longs in the coming weeks.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report , "Introducing An FX Trading Model", dated April 24, 2020. 2 Please see Foreign Exchange Strategy Special Report , "Currencies And The Value-Vs Growth Debate", dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: Headline consumer price inflation increased from 0.1% to 0.6% year-on-year in June. Core inflation was unchanged at 1.2% year-on-year. The NFIB business optimism index increased from 94.4 in May to 100.6. The NY Empire State manufacturing index surged from -0.2 to 17.2 in July. Producer prices fell by 0.8% year-on-year in June. Initial jobless claims increased by 1300K for the week ended July 10th. The DXY index fell by 0.7% this week. Risk sentiment continues to improve with higher hopes for vaccine and the reopening of economies. The Fed’s Beige Book released this Wednesday shows that economic activities are recovering in a lot of districts though well below pre-COVID-19 levels. It is remarkable that retail sales surged, led by a rebound in vehicle sales and home improvement purchases. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index ticked up from 58.6 to 59.6 in July. Industrial production fell by 20.9% year-on-year in May, following a 28.7% contraction the previous month.  The trade balance surged from €1.6 billion to €8 billion in May. The euro appreciated by 1.1% against the US dollar this week. The ECB kept policy unchanged this week. As interest rate spreads between the core and periphery converge, the ECB’s work is done. We remain positive on the euro against the US dollar, though petrocurrencies and the British pound will likely outperform should our bet on high-beta currencies pan out. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Industrial production plunged by 26.3% year-on-year in May, following a 25.9% contraction the previous month. Capacity utilization continued to fall by 11.6% year-on-year in May. The Japanese yen appreciated by 0.5% against the US dollar this week. The BoJ maintained its interest rate at -0.1% on Tuesday and made no changes to its asset purchase program. While Governor Haruhiko Kuroda warned the outlook remains highly uncertain (including downgrading the economic forecast for 2020), he sounded conciliatory to the fact that fiscal policy might be needed to boost Japanese demand. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The total trade surplus widened from £2.3 billion to £4.3 billion in May, boosted by a 6.6% jump in goods sales. Retail sales surged by 10.9% yearly in June. Both headline and core inflation increased to 0.6% and 1.4% year-on-year, respectively in June. The unemployment stayed flat at 3.9% in May. Average earnings fell by 0.3% year-on-year in the 3 months to May. However, industrial production fell by 20% year-on-year in May. The British pound was flat against the US dollar this week. The UK economy contracted by 19.1% in the three months to May, according to ONS data. GDP grew by 1.8% month-on-month in May alone, but this is still 25% below the February level. On the positive side, NIESR forecasts that the UK economy is likely to recover by 8-10% in the third quarter of 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: NAB business confidence increased from -20 to 1 in June. The business conditions index also jumped from -24 to -7. New home sales surged by 87.2% month-on-month in May. Employment increased by 210.8K in June, with an increase of 249K part-time jobs and a loss of 38.1K full-time jobs. The Australian dollar appreciated by 0.9% against the US dollar this week. The latest Labor Force Survey shows positive developments in recent months. While the unemployment rate ticked up slightly, both the underemployment rate and underutilisation rate declined by 1.4% and 1%, respectively in June. Moreover, the participation rate increased by 1.3% to 64%. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative:  Visitor arrivals plunged in May amid the global pandemic. ANZ monthly inflation gauge fell from 2.8% year-on-year to 2.4% year-on-year in June. Headline consumer price inflation slowed from 2.5% to 1.5% year-on-year in Q2. The New Zealand dollar fell by 0.2% against the US dollar this week. As we mentioned in last week’s report, the government’s effort to limit the spread of COVID-19 and curb immigration will hurt New Zealand’s labor market. The “Migration after COVID-19” released by NZIER this week also implied more restrictive immigration policy going forward. Stay short NZD/CAD. 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 II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: In June, the unemployment rate declined from 13.7% to 12.3%. The participation rate also increased from 61.4% to 63.8%. Manufacturing sales surged by 10.7% month-on-month in May, following a 27.9% decline the previous month. The Canadian dollar appreciated by 0.4% against the US dollar this week. On Wednesday, the BoC kept its benchmark interest rate unchanged, as widely expected. BoC’s new Governor Tiff Macklem said that “it’s going to be a long climb out” and implied that interest rates are likely to stay unusually low for a long time. 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 II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices declined by 3.5% year-on-year in June, following a 4.5% contraction the previous month. Total sight deposit continued to increase from CHF 687 billion to CHF 688.6 billion for the week ended July 10th. The Swiss franc fell by 0.2% against the US dollar this week. In a speech this Tuesday, SNB Chairman Thomas Jordan said that the current policy in place since 2015 is unlikely to change anytime soon. He also acknowledged that the SNB had intervened in the FX market more strongly in recent months to ease upward pressure on the franc amid the global pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Headline consumer prices increased by 1.4% year-on-year in June. Core inflation surged by 3.1% year-on-year in June, the highest since August 2016. Producer prices fell by 14.4% year-on-year in June, following a 17.5% contraction the previous month.  The trade deficit widened from NOK1.2 billion to NOK10.2 billion in June. Exports fell by 15.6% year-on-year while imports rose by 10%, with a surge in food and manufactured goods purchases. The Norwegian krone increased by 2% against the US dollar this week. While the Norwegian krone has rebounded by 22% since the March lows, it is still 7-10% cheaper compared with pre-COVID-19 levels. Our bias is that the Norwegian krone still has tremendous room to run towards its fair value. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Headline consumer price inflation rose to 0.7% year-on-year in June, from -0.4% in April. Food and non-alcoholic beverages inflation slowed from 3.9% year-on-year the previous month but remained high at 2.6% year-on-year in June. The Swedish krona jumped by 2% against the US dollar this week on the back of positive inflation data. A bit less than the Norwegian krone, the Swedish krona has increased by 13% since its March lows but is still far below the value prior to COVID-19. We maintain a positive stance towards both NOK and SEK. Our Nordic basket is now 11% in the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature Over the last several years when I travelled to Europe, I would meet with Ms. Mea, an outspoken client of the Emerging Markets Strategy service. We have published our conversations with Ms. Mea in the past and this semi-annual series has complemented our regular reports. She has challenged our views and convictions, serving as a voice for many other clients. In addition, these conversations have highlighted nuances of our analysis, for her and to the benefit of our readers. With travel restrictions in force, this time we had to resort to an online meeting with Ms. Mea. Below are the key parts of our conversation from earlier this week. Ms. Mea: Let’s begin with your main thesis, which over the past several years has been as follows: China’s growth drives EM business cycles and financial markets overall. Indeed, as long as China’s growth dithers, EM growth and asset prices languish. However, since the pandemic started China has stimulated aggressively and there are clear signs that the economy is recovering. The latest surge in Chinese share prices confirms that a robust recovery is underway. Why do you not think China’s economy is on the upswing? Answer: True, we believe China’s business cycle is instrumental to EM economies’ growth and balance of payments. We upgraded our outlook for Chinese growth in our May 28 report as the National People’s Congress set the objective for monetary policy in 2020 to significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth as well as both private and public credit have accelerated since April and will continue to increase (Chart I-1). Domestic orders have also surged though export orders are still languishing (Chart I-2). Chart I-1China: Money And Credit Will Continue Accelerating China: Money And Credit Will Continue Accelerating China: Money And Credit Will Continue Accelerating Chart I-2China: Improvement In Domestic Orders But Not In Export Ones China: Improvement In Domestic Orders But Not In Export Ones China: Improvement In Domestic Orders But Not In Export Ones     That said, financial markets, including the ones leveraged to China, have run ahead of fundamentals and a pullback is overdue. We have been waiting for such a setback to turn more positive on EM risk assets and currencies. Further, the snapback in business activity following the lockdown should not be confused with an economic expansion. As economies around the world reopened, business activity was bound to improve. Were any asset markets priced to reflect months or a whole year of closures? Even at the nadir of the global equity selloff in late March, we do not think risk assets were priced for extended lockdowns. The Chinese economy will likely eventually experience a robust expansion later this year but the nearterm outlook for global risk assets and commodities remains risky. In our view, the rally in global stocks and commodities has been much stronger than is warranted by the near-term economic conditions in a majority of economies around the world. In short, we have not been surprised at all by the economic data that has emerged since economies have reopened, but we have been perplexed by the markets’ response to these data. Even in China, which is ahead of all other countries in regards to the reopening and normalization of business activity, the level and thrust of economic activity remains worrisome. Specifically: China's manufacturing PMI new orders and the backlog of orders sub-components remain below the neutral 50 line (Chart I-3). The imports subcomponent of the manufacturing PMI has shown signs of peaking below the 50 line, portending a risk to industrial metals prices (Chart I-4). Chart I-3China Manufacturing PMI: Measures Of Orders Are Still Below 50 China Manufacturing PMI: Measures Of Orders Are Still Below 50 China Manufacturing PMI: Measures Of Orders Are Still Below 50 Chart I-4A Yellow Flag For Commodities A Yellow Flag For Commodities A Yellow Flag For Commodities   Marginal propensity to spend for both enterprises and households continues to trend lower (Chart I-5). These gauge the willingness of consumers and companies to spend and, hence, reflect the multiplier effect of the stimulus. These indicators contend that the multiplier so far remains low/weak. Finally, with the exception of new economy stocks (such as Ali-Baba and Tencent) that have been exceptionally strong worldwide, Chinese share prices leveraged to capital expenditure and consumer discretionary spending had not been particularly strong before last week, as illustrated in Chart I-6.  Chart I-5Marginal Propensity To Spend Among Chinese Households And Enterprises Marginal Propensity To Spend Among Chinese Households And Enterprises Marginal Propensity To Spend Among Chinese Households And Enterprises Chart I-6Chinese Stocks Had Been Languishing Till Late Outside New Economy Ones Chinese Stocks Had Been Languishing Till Late Outside New Economy Ones Chinese Stocks Had Been Languishing Till Late Outside New Economy Ones In a nutshell, the Chinese economy will likely eventually experience a robust expansion later this year but the near-term outlook for global risk assets and commodities remains risky. As to EM risk assets, the key risk to our stance is a FOMO-driven rally buoyed by the “visible hand” of governments. Ms. Mea: What is your interpretation of the latest policy push in China for higher share prices? Is it also a part of the “visible hand” of government? Don’t you think this could create another strong multi-month run like it did in early 2015? Answer: Yes, this is one of many instances of the “visible hand” of governments around the world. It is not clear why Beijing is boosting investor sentiment and explicitly promoting higher share prices given how badly similar efforts in 2015 ultimately ended. At the moment, we can only speculate that one or several of the following reasons are behind this move: Beijing is preparing for an escalation in the US-China geopolitical confrontation ahead of the US presidential elections. This latter is highly probable in our opinion.1 To limit the impact of this confrontation on their economy, they want to ensure that the stock market remains in an uptrend. The same can be said for the US authorities. Apparently, the “visible hands” of both Washington and Beijing have and will continue to push share prices higher in their domestic markets. Robust equity markets will become a prominent feature of the geopolitical confrontation between the US and China. In the long run, however, this is a very negative phenomenon for the world because the two of the largest and most prominent stock markets could increasingly be driven by the “visible hand” of their governments rather than by fundamentals. As a result, equity markets could regularly send wrong price signals and will no longer serve as an efficient mechanism of capital allocation. Chart I-7Foreign Inflows Into China Have Accelerated This Year Foreign Inflows Into China Have Accelerated This Year Foreign Inflows Into China Have Accelerated This Year Beijing has been luring foreign investors to buy onshore stocks and bonds and this strategy has become more vital in expectation of an escalation in the US-China confrontation. Chart I-7 shows that net inflows into onshore stocks and bonds have been surging. The more US investors buy into mainland markets, the more these investors will exercise pressure on the current and future US administrations to go soft on China. Like those US companies relying on Chinese demand, large US investment funds will have a notable exposure to Chinese financial markets and will accordingly lobby the White House and Congress to take a less adversarial stance toward China. This will reduce the maneuvering room of US politicians in this geopolitical confrontation. Finally, it is also possible that these latest media reports encouraging a bull market in China were not initiated by leaders in Beijing but were in fact spurred by mid-level bureaucrats. If that is the case, a full-blown mania akin to the one in 2015 will not be repeated and the latest frenzy surrounding Chinese stocks could end up being the final surge before a correction sets in. In brief, Chinese stocks, like other bourses worldwide, are in a FOMO-driven mania that might last for a while. Nevertheless, regardless of the direction of Chinese stocks in absolute terms, we reiterate our overweight stance on Chinese equities within the EM benchmark. Also, we have a strong conviction with respect to the merits of a long Chinese/short Korean stocks trade. Both these positions were initiated on June 18 before the latest surge in Chinese stocks. The “visible hands” of both Washington and Beijing have and will continue to push share prices higher in their domestic markets. Ms. Mea: What will it take for you to go long EM risk assets and currencies in absolute terms? Answer: EM equities, credit markets and currencies are driven by three, or more recently four, factors. We need to witness or foresee an imminent improvement in three out of four of these to go outright long. These factors include: (1) China’s business cycle and its impact on EM via global trade; (2) each individual EM country’s domestic fundamentals (inflation/deflation, balance of payments, return on capital, domestic economic cycles, monetary and fiscal policies, health of the banking system, domestic politics, etc.); (3) global risk-on and risk-off cycles that drive portfolio flows into EM. The direction of the S&P500 is an important trendsetter for these risk-on and risk-off cycles; (4) swings in geopolitical confrontation between the US and China. The first element – China’s impact on EM – is becoming positive. There could be a minor setback in mainland business cycles in the near term, but this should be used as a buying opportunity. As to structural problems in China like credit/money and property bubbles as well as the misallocation of capital, ongoing money and credit growth acceleration will fill in holes and kick the can down the road. That said, those structural problems will become even more challenging in the years to come. In short, Beijing is making credit, money and property bubbles even bigger. The second factor – domestic fundamentals in EM ex-China, Korea and Taiwan – remain downbeat. The COVID-19 outbreak has been out of control in a number of EM economies (Chart I-8). In addition, outside of China, Korea and Taiwan, EM fiscal stimulus has not been as large as in DM economies. Critically, the monetary transmission mechanism has been broken in several developing economies. In particular, central banks’ rate cuts have not translated to lower lending rates in real terms (Chart I-9). Chart I-8The COVID-19 Pandemic Has Not Peaked In Several Major EM Economies The COVID-19 Pandemic Has Not Peaked In Several Major EM Economies The COVID-19 Pandemic Has Not Peaked In Several Major EM Economies Chart I-9Lending Rates Are Still High In EM ex-China, Korea And Taiwan Lending Rates Are Still High In EM ex-China, Korea And Taiwan Lending Rates Are Still High In EM ex-China, Korea And Taiwan   The basis is two-fold: First, banks saddled with non-performing loans are reluctant to bring down their lending rates and lend more; and second, the considerable decline in EM inflation has pushed up real lending rates (Chart I-9). The third variable driving EM financial markets – the S&P 500 – remains at risk of a material setback. If the S&P drops more than 10 or 15%, EM stocks, currencies and credit markets will also sell off markedly. Finally, there is the fourth aspect of the EM view – geopolitics – which could be critical in the coming months. The US-China confrontation will likely heighten leading up to the US elections. This will likely involve North and South Korea and Taiwan. Chart I-10EM ex-China, Korea And Taiwan: Stocks And Currencies EM ex-China, Korea And Taiwan: Stocks And Currencies EM ex-China, Korea And Taiwan: Stocks And Currencies Chinese investable stocks as well as Korean and Taiwanese equities altogether make up 65% of the MSCI EM benchmark. Hence, a flareup in geopolitical tensions will weigh on these three bourses. Outside these markets, EM share prices and currencies have already rolled over (Chart I-10). In sum, out of the four factors listed above only the Chinese business cycle warrants an upgrade on overall EM. The other three drivers of the EM view are still negative. This keeps us on the sidelines for now. Importantly, we have been gradually moving our investment strategy from bearish to neutral on EM. Specifically, we: Took profits on the long EM currencies volatility trade on March 5. Took large profits on the long gold / short oil and copper trade on March 11. Booked gains on the short position in EM stocks on March 19. Recommended receiving long-term (10-year) swap rates (or buying local currency bonds while hedging the exchange rate risk) in many EMs on April 23. Upgraded EM sovereign credit from underweight and booked profits on our short EM corporate and sovereign credit / long US investment grade bonds strategy on June 4. The only asset class where we have not yet closed our shorts is EM currencies. In fact, we now recommend shifting our short in EM currencies (BRL, CLP, ZAR, TRY, KRW, PHP and IDR) from the US dollar to an equal-weighted basket of the Swiss franc, the euro and the Japanese yen. Unlike the March selloff, the dollar could depreciate even if the S&P 500 and global stocks drop. Ms. Mea: What is the rationale behind switching your short positions in EM currencies against the US dollar to short positions versus the Swiss franc, the euro and Japanese yen? Wouldn’t the selloff in global stocks drive the greenback higher? Answer: We have been bullish on the US dollar since 2011, consistent with our negative view on EM and commodities prices and recommendation of favoring the S&P 500 versus EM. What is making us question this strategy are the following, in order of importance: First, the Federal Reserve is monetizing US public and some private debt. The amount of US dollars is surging. Meanwhile, the pace of broad money supply growth is much more timid in the euro area, Switzerland and Japan. Broad money growth is 23% in the US, 9% in the euro area, 2.5% in Switzerland, 5% in Japan and 11% in China. This will reduce investors’ willingness to hold dollars as a store of value, incentivizing them to switch to other DM currencies. Second, the pandemic is out of control in the US and this will damage its near-term growth outlook. More fiscal stimulus and more debt monetization will be required to revive the economy. Third, the Fed will not hike interest rates even if inflation rises well above their 2% target in the next several years. This implies that the Fed will prefer to be behind the inflation curve in the years to come, which is bearish for the greenback. Finally, the yen and the euro as well as EM currencies are cheaper than the US dollar (Chart I-11 and Chart I-12). Chart I-11The US Dollar Is Expensive, The Yen Is Cheap The US Dollar Is Expensive, The Yen Is Cheap The US Dollar Is Expensive, The Yen Is Cheap Chart I-12EM ex-China, Korea And Taiwan: Currencies Are Cheap EM ex-China, Korea And Taiwan: Currencies Are Cheap EM ex-China, Korea And Taiwan: Currencies Are Cheap     The broad trade-weighted US dollar has yet to break down as per the top panel of Chart I-13, but we are becoming nervous about it. Unlike the March selloff, the dollar could depreciate even if the S&P 500 and global stocks drop. Ms. Mea: That is interesting. Has there ever been an episode where the US dollar depreciated while the S&P 500 sold off? Answer: Yes, it occurred in late 2007 and H1 2008. The 2007-08 bear market in global stocks can be split into two periods. During the initial phase of that bear market, the US dollar depreciated substantially despite the drawdowns in global equity and credit markets (Chart I-14, top and middle panels). Chart I-13Trade-Weighted Dollar And Asian Currencies: At A Critical Juncture Trade-Weighted Dollar And Asian Currencies: At A Critical Juncture Trade-Weighted Dollar And Asian Currencies: At A Critical Juncture Chart I-14In Late 2007 And H1 2008: The US Dollar Fell Amid An Equity Bear Market In Late 2007 And H1 2008: The US Dollar Fell Amid An Equity Bear Market In Late 2007 And H1 2008: The US Dollar Fell Amid An Equity Bear Market   EM stocks performed in line with DM ones during the first phase (Chart I-14, bottom panel). The economic backdrop was characterized by the US recession and US banks tightening credit. In fact, EM growth was still robust during that phase even though the US economy was shrinking. Remarkably, commodities prices were surging – oil reached $140 per a barrel and copper $4 per ton in June 2008. The second phase of that bear market commenced in autumn of 2008 when Lehman went bust. The orderly bear market in global stocks gave way to an acute phase – a crash in all global risk assets. Business activity collapsed worldwide and the US dollar surged. In the current cycle, the order will likely be the reverse of the 2007-08 bear market. March 2020 witnessed a crash in global risk assets and the global economy plunged similar to the second phase of the 2007-08 bear market while the US dollar surged. The second stage of this recession could resemble the first phase of the 2007-08 bear market. There will be neither worldwide lockdowns nor a crash in business activity. However, the level of activity might struggle to recover as rapidly as markets have priced in or there might be relapses in economic conditions in certain parts of the world. This is especially true for the US and other countries where the pandemic has not been effectively contained. On the whole, the second downleg in the S&P 500 and global stocks will be less dramatic but could last for a while and still be meaningful (more than 10-15%). Critically, unlike the March 2020 selloff, the greenback will likely struggle during this episode for the reasons we outlined above. Ms. Mea: What about overweighting EM equities and credit versus their DM peers? Will EM equities, credit and currencies underperform their DM peers in the potential selloff that you expect? Wouldn’t USD weakness help EM risk assets to outperform even in a broad risk selloff? Answer: Yes, we can see a scenario where EM stocks and credit markets perform in line or better than their DM peers in a potential selloff. The key is the dollar’s dynamics. If the dollar rebounds, EM stocks and credit markets will underperform their DM counterparts. If the dollar weakens during this selloff, EM stocks and credit will likely perform in line with or better than their DM peers. In sum, a technical breakdown in the broad trade-weighted dollar and a breakout in the emerging Asian currency index – both shown in Chart I-13 – would lead us to upgrade our EM allocation in both global equity and credit portfolios. For now, we are only switching our shorts in EM currencies from the US dollar to an equally-weighted basket of the Swiss franc, the euro and the Japanese yen. Ms. Mea: What are some of your other current observations on financial markets? Answer: The breadth and thrust of this global equity rally has already peaked and is weakening. It is just a matter of time before a narrowing breadth translates into lower aggregate stock indexes for both EM and DM equities as illustrated by our advance-decline lines in Chart I-15. Chart I-15EM and DM Equity Breadth Measures Have Rolled Over EM and DM Equity Breadth Measures Have Rolled Over EM and DM Equity Breadth Measures Have Rolled Over Chart I-16Cyclicals And High-Beta Stocks Have Been Struggling Cyclicals and High-Beta Stocks Have Been Struggling Cyclicals and High-Beta Stocks Have Been Struggling Consistently, there has already been a decoupling between various sectors and industries. The rally has been solely focused on tech and new economy stocks. Equity prices in China and Taiwan have been surging while the rest of the EM equity index has been languishing. In the DM equity space, global industrials, US high-beta stocks and micro caps have already rolled over (Chart I-16). Further, our Risk-On/Safe-Haven currency index is flashing red for EM equities (Chart I-17). Chart I-17A Red Flag For EM Equities? A Red Flag For EM Equities? A Red Flag For EM Equities? Chart I-18Long Gold / Short Stocks Long Gold / Short Stocks Long Gold / Short Stocks Finally, EM share prices have outperformed DM stocks since late May mostly due to the sharp rally in Chinese, Korean and Taiwanese stocks. Hence, the breadth of EM equity outperformance has been subdued. Ms. Mea: To wrap up our conversation, I want to ask you what is your strongest conviction trade for the coming months? Answer: Our strongest conviction trade is long gold / short global or EM stocks (Chart I-18). This trade will do well regardless of the direction of global share prices, the US dollar, and bond yields. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report "Watch Out For A Second Wave (Of US-China Frictions)," dated June 10, 2020, available at gps.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs Why Housing Costs Matter More Than Ever Why Housing Costs Matter More Than Ever This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration ...Will Prove To Be A Brief Aberration ...Will Prove To Be A Brief Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB GBP/RUB GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 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 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