Manufacturing

Highlights The Swiss economy will benefit from the pickup in global growth. The recent weakness in the franc has been a welcome development for the Swiss National Bank, but technicals suggest a coiled spring rally in CHF is likely. However, as a low-beta currency, the Swiss franc will lag the upturn in other pro-cyclical currencies over the longer term. We remain long EUR/CHF as a tactical trade but maintain tight stops at 1.095. Long CHF/NZD and CHF/GBP positions look attractive at current levels. Similar to our short EUR/JPY position, this is an excellent portfolio hedge. Feature Chart I-1The Swiss Economy Is On The Mend The Swiss economy has recovered smartly. As of March, the manufacturing PMI was at 66.3, the highest since 2006. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades (Chart I-1). This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. The Swiss franc has been one of the worst performing currencies this year, but that might be about to change. For one, dollar sentiment has been reset with the rise in the DXY index this year. Second, the global economy is transitioning from disinflationary to a gentle tilt towards inflation. This will lift global prices, including import prices into Switzerland. Rising import prices will ease the need for the SNB to maintain emergency monetary settings. Finally, the weakness in the currency has eased financial conditions for Swiss concerns. The Reopening Trade Most economies are entering into a third wave of the Covid-19 pandemic and the Swiss economy is no exception. However, the Swiss authorities have been able to bring the number of new infections down to levels below the euro area in general and Sweden in particular. Vaccinations are progressing smoothly with almost 20% of the population inoculated as of today. This provides a coiled springboard to lift the Swiss economy into robust growth later this year. Switzerland is one of the most open economies in the G10. Exports of goods and services account for over 65% of Swiss GDP, much higher than the euro area (Chart I-2). The constituent of Swiss exports tends to be defensive (medical goods, gold, watches, jewelry) so the franc does not necessarily outperform in a global growth upswing, but definitely does better than the dollar which anchors a more closed economy. Inflation dynamics in Switzerland will be particularly beholden to improvement in the private sector. As we show in Chart I-1, employment should remain robust in the months ahead, which will support wages. Import prices in Switzerland are also about to catapult upwards, which will help lift the consumer price basket (Chart I-3). For a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation, and the weakness in the franc has been a beneficial cushion for good prices. The rise in global tradeable prices is also acting as a catalyst. For the first time in many years, the pendulum might be swinging towards a worry about inflation in SNB corridors. Chart I-2Switzerland Has A Huge Exposure To Trade Chart I-3Swiss Inflation Will Rise Particularly, a rise in Swiss inflation will lessen the need for the SNB to keep rates at the -0.75 level in place for over half a decade. It will also lessen to need for the SNB to fight against franc strength.  Global Developments In A CHF Context There are some additional tailwinds to a strong CHF in today’s context. Volatility has collapsed, with the VIX index well below 20. If one could predict with absolute certainty what will happen with global growth, equity prices, bond yields, or even Covid-19, then low volatility makes sense. However, in the current context of elevated valuations, high uncertainty and a precarious health landscape, it almost makes perfect sense that volatility should rise. The franc tends to do well in an environment where volatility is rising (Chart I-4). Chart I-4The Swiss Franc Tracks The VIX Chart I-5Long-Term Support On CHF/NZD Has Held In fact, from a broad picture perspective, a rotation from US growth outperformance to other parts of the globe that are also stimulating their domestic economies could be met with higher dollar volatility. This has historically been beneficial for the Swiss franc (Chart I-6). Ergo, being long the franc could constitute a “heads, I win; tails I do not lose too much” proposition. Rising global growth and a lower dollar will help the franc, but so will a rise in volatility. Chart I-6CHF/NZD Tracks Dollar Volatility Our Geopolitical Strategy team has also been recommending long Swiss franc positions since February as they believe the Biden administration faces several imminent and serious foreign policy tests, namely over Russia’s military buildup on the Ukraine border, China’s military pressure tactics against Taiwan, and Middle East tensions ahead of any revived US-Iran nuclear deal. They see a 60% chance of some kind of crisis – if not war – over the Taiwan Strait and any of these other issues could also motivate safe haven demand for the rest of this year.  With regard to CHF/GBP, an upside surprise for the Scottish National Party in the May 6 parliamentary election could also hurt the pound since it would herald a second Scots independence referendum in the not-too-distant future. Trading Dynamics As A Safe Haven Chart I-7CHF And The Copper/Gold Ratio Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of over 100% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion. This makes the franc a useful constituent of any currency portfolio. More specifically, the franc has tracked the gold-to-copper ratio in recent years. Copper is a good barometer for global economic health while gold is a good proxy for the demand for safety. If the overarching theme is that complacency reigns across markets, a nudge towards safety will benefit flows into the franc (Chart I-7). The current interest-rate regime could also affect the franc-dollar relationship. Global yields have risen. To the extent that we are due for some reprieve, the franc will benefit, given its “low beta” status. Meanwhile, net portfolio flows into Switzerland suffered from the Trump tax cuts that pushed US affiliates in Switzerland to repatriate investments. President Biden’s tax reform will halt and/or reverse this process. SNB Action And Market Implications The past weakness in the franc has been a welcome development for the SNB. In fact, since the start of this year, Swiss central bankers have not had to ramp up asset purchases. Both the dollar and the euro have been relatively strong (Chart I-8). In other words, global dynamics have eased monetary conditions for the Swiss authorities. The latest Article IV report from the IMF also justifies the SNB’s monetary stance. Currency intervention was cited as a viable tool should the SNB do a policy review, especially given the potential inefficacies from QE due to the small bond market in Switzerland. Herein lies the key takeaway for the franc – while it could appreciate in an environment where the dollar resumes its downtrend, it will likely lag other pro cyclical currencies over the longer term. This is because the SNB will be loath to see the franc unanchor inflation expectations. We are long EUR/CHF on this basis, but are keeping tight stops at 1.095. Three key factors suggest this trade could still work well in the coming 12-18 months. Rising interest rates benefit EUR/CHF (Chart I-9). With interest rates in Switzerland well below other countries, the Swiss franc rapidly becomes a funding currency for carry trades. Carry trades, especially towards peripheral bonds in Europe hurt the franc. Chart I-8A Weaker Franc Is Doing The Heavy Lifting For The SNB Chart I-9EUR/CHF Tracks German ##br## Yields The Swiss trade balance has suffered in the face of a global slowdown. It will also lag the European rebound (Chart I-10). In a downturn, commoditized goods prices are the first to drop and recover, while more specialized goods prices eventually gain ground later. Swiss goods are not easily substitutable which is a benefit, but prices are also slower to adjust. Our models suggest the franc is still about 5% overvalued versus the euro. Over the history of the model, this has been a modest premium, but allows the euro to outperform the Swiss franc (Chart I-11). Chart I-10Structural Appreciation In The Swiss Franc Chart I-11EUR/CHF Is Still Cheap Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G10 (Chart I-12). Too little stimulus and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations are revised downwards. Too much stimulus and the result will be a build-up of imbalances, leading to an eventual bust. Chart I-12Lots Of Private Debt In Switzerland Today, the SNB is in a sweet spot. Almost every other G10 country is providing the fiscal and monetary stimulus necessary to lift Switzerland from its deflationary paradigm. Investment Conclusions Chart I-13Structural Appreciation In The Franc Still Possible Our long-term fair value models suggest the Swiss franc is currently cheap versus the dollar (Chart I-13). This makes it attractive from a strategic perspective. Usually, the Swiss franc tends to be more of a dormant currency, gently appreciating towards fair value but periodically interspersed with bouts of intense volatility. Interestingly, we may be entering such a riot point. The VIX is low and countries are reintroducing lockdowns, yet overall sentiment remains unequivocally bullish. Finally, Switzerland ticks off all the characteristics of a safe-haven currency. As such, while the dollar has benefited from its reserve status, the franc remains an appropriate hedge in any currency portfolio. In a nutshell, our recommendations are as follows: USD/CHF will stay under parity. EUR/CHF can hit 1.2. NZD/CHF is a sell in the short-term. So is GBP/CHF. The Scandinavian currencies will outperform the franc on a 12-18 month horizon.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 US economic data has been spectacular this week: Starting with the jobs report, the US added 916K jobs in March versus a consensus of 660K jobs. The unemployment rate fell from 6.2% to 6% and wages increased by 4.2% year-on-year. The boost to domestic demand dented the trade balance. The deficit widened from $68.2bn to $71.1bn in February. The FOMC minutes were a non event for markets. The DXY index is giving back some of the gains it accumulated this year, rising over 1% this week. With the US 10-year yield now facing strong resistance near the 1.7% level, the case for a stronger USD is fading. As consensus forecasts coagulate towards a stronger USD, positioning has also been reset towards USD long positions auguring for some volatility in the months ahead. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area are mending: The Sentix investor index catapulted from 5 to 13.1 in April. The Eurozone remains the unsung hero in this recovery. PPI increased to 1.5% year-on-year in February from 0% last month. The euro rose by 1.2% against the dollar this week. To be clear, there are still stale euro longs among more fundamental holders of the currency. This suggests the flushing out of weak hands has more to go. However, the balance of evidence suggests euro area data could reward long positions later this year.  Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been improving: PMI indices remain under 50, but reflect a possible coiled-spring rebound underway. Consumer confidence rebounded from 33.8 to 36.1 in March. The Eco Watchers survey was also encouraging. Sentiment rebounded from 41.3 to 49 in March. The Japanese yen rose by 1.24% against the US dollar this week, and remains the strongest G10 currency in recent trading days. Falling yields have seen Japanese investors retreat from overseas markets such as the UK, pushing up the yen. Speculative positioning is also net yen bearish, which is constructive from a contrarian standpoint. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been positive: Car registrations are picking up smartly, suggesting durable demand might be returning to the UK. Registrations rose 11.5% year-on-year in March versus -35.5% the year before. The UK construction PMI hit a high of 61.7, the highest since 2014. The pound fell by almost 2% versus the euro this week. The violent correction in EURGBP might be a harbinger of the rotation brewing for both UK and US assets versus their global counterparts. Stay tuned. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: The RBA kept rates unchanged at 0.1%. Both the services and manufacturing PMIs remained at an expansionary 55.5 level. The Aussie rose by 0.4% this week. We like the AUD, and are long AUD/NZD as a trade. However, the outperformance of the US economy is also handsomely rewarding AUD/MXN shorts. Mexico benefits a lot more from a pick-up in the US economy than Australia. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data out of New Zealand have been positive: The ANZ commodity price index ticked up by 6.1% in March. ANZ Business confidence deteriorated in March. The activity outlook fell from 16.6 to 16.4 and confidence fell from -4.1 to -8.4. The New Zealand dollar rose by 60bps against the US dollar this week. New Zealand will start taking the back seat in the coming economic rotation as other economies play catch up. The improvement in kiwi terms of trade has been a boon for the currency, and will limit downside on NZD. However, shorting the NZD at the crosses remains an attractive proposition. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 There was scant data out of Canada this week: The Bloomberg Nanos confidence index continues to suggest that Canadian GDP will surprise to the upside. The index rose from 63.7 to 64.1 last week. Demand for Canadian goods remains robust. The trade surplus came in at C$1.04bn in February. The Ivey purchasing managers’ index catapulted to 72.9 from 60 in March. The Canadian dollar was flat against the US dollar this week. While this might come as a surprise, three reasons explain this performance. First, the loonie is one of the best-performing G10 currencies this year and some specter of rotation was in play this week. Second, the correction in oil prices hurt the loonie. Finally, should US economic optimism become more widespread, other currencies could benefit. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Sight deposits were relatively flat at CHF700bn last week. The Swiss Franc rose by 2% against the US dollar this week. This week’s piece is dedicated to the possibility that the franc has a coiled-spring rebound in the near term. Safe-haven currencies are now benefitting from the drop in yields, while the franc has underperformed other currencies this year. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The March DNB manufacturing PMI came in at 56.1 from 57.5. Industrial production rose by 5.9% year-on-year versus expectations of a 1.5% increase. The NOK rose by 0.75% against the dollar this week. Norway has handled the Covid-19 crisis admirably and it is an added boon that oil prices, a key export and income valve for Norway, are rising smartly. This has prompted the Norges bank to rapidly bring forward rate hike expectations. This leaves little scope for the NOK to fall durably. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data releases were above expectations: The Swedbank manufacturing PMI came in at 63.7 in March versus expectations of 62.5. Industrial orders came in at 8.5% year-on-year versus expectations of 5.3% in February. The Swedish krona rose by 2% this week ranking it as the best performing G10 currency. Sweden needs to do a better job at containing the Covid-19 crisis, which will unlock tremendous value in the krona. As a positive, the global manufacturing cycle continues humming and will buffeting Swedish industrial production. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights The Eurozone economy and assets remain beholden to the global manufacturing cycle. This sensitivity reflects the large share of output generated by capex and exports. Yet, the second half of 2021 and first half of 2022 could see euro area growth follow the beat of its own drum. This is a consequence of the unique role of consumption in the COVID-19 recession. European growth will therefore outperform expectations, even if economic momentum slows outside of Europe. Consequently, the euro and Eurozone equities will outperform for the coming 12 to 18 months. Feature For the past 20 years, investors have used a simple rule of thumb to understand European growth and markets. Europe is a derivative of global growth because of its large manufacturing sector and torpid domestic economy. A reductionist approach would even argue that China’s economy is what matters most for Europe. Is this model still valid to analyze Europe? In general, this approach still holds up well. However, the nature of the 2020 COVID-19 recession suggests that the European economy could still accelerate in the second half of the year, despite a small slowdown in the Chinese economy and global manufacturing sector. The Origin Of The Pro-Cyclicality Narrative Investors in European markets have long understood that Eurozone equities outperform when the global manufacturing cycle accelerates. This pro-cyclicality of European stocks is a consequence of their heavy weighting toward cyclical and value stocks, such as industrials, consumer discretionary and financials. Chart 1German/US Spreads: Global Manufacturing Cycle Historically, European yields have also moved in a very pro-cyclical fashion. Over the past 30 years, periods when German 10-year yields rose relative to that of US Treasury Notes have coincided with an improvement in the global manufacturing sector as approximated by the ISM Manufacturing survey (Chart 1). Investors also understand that the euro is a pro-cyclical currency. Some of this behavior reflects the counter-cyclicality of the US dollar. However, if German yields rise more than US ones when global growth improves and European equities outperform under similar conditions, the euro naturally attracts inflows when the global manufacturing sector strengthens. Chart 2China Is A Key Determinant Of European Activity Ultimately, the responsiveness of the euro and European assets to global growth is rooted in the nature of the European economy. Trade and manufacturing account for nearly 40% and 14% of GDP, respectively, compared to 26% and 11% for the US. This economic specialization has made Europe extremely sensitive to the gyrations of the Chinese economy, the largest contributor to fluctuation in the global demand for capital goods. As Chart 2 highlights, European IP and PMI outperform the US when China’s marginal propensity to consume (as approximated by the growth in M1 relative to M2) picks up. Is The Pro-Cyclical Narrative Still Valid? Despite the euro area debt crisis and the slow health and fiscal policy response of European authorities to COVID-19, evidence suggests that the Eurozone’s pro-cyclicality is only increasing. Chart 3Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World A simple statistical analysis confirms this hypothesis. A look at the beta of European GDP growth against the Global PMI reveals that the sensitivity of Eurozone growth and German growth to the Global PMI has steadily increased over the past 20 years (Chart 3, top panel). Moreover, the beta of euro area growth to the global PMI is now higher than that of the US, despite a considerably lower potential GDP growth, which means that a greater proportion of the Eurozone’s GDP growth is affected by globally-driven fluctuations. The bottom panel of Chart 3 shows a more volatile but similar relationship with Chinese economic activity. Correlation analysis confirms that Europe remains very sensitive to global factors. Currently, the rolling correlation of a regression of Eurozone GDP growth versus that of China stands near 0.7, which is comparable to levels that prevailed between 2005 and 2012. The correlation between German and Chinese GDP growth is now higher than at any point during the past two decades. Chart 4The Declining Role Of Consumption The increasing influence of global economic variables on the European economy reflects the evolution of the composition of the Eurozone’s GDP. Over the past 11 years, the share of consumption within GDP has decreased from 57% to 52%. For comparison’s sake, consumption accounts for 71% of US GDP. The two sectors that have taken the primacy away from consumption are capex and net exports, whose combined share has grown from 22% to 26% of GDP (Chart 4). This shift in the composition of GDP echoes the structural forces facing the Eurozone. An ageing population, a banking system focused on rebuilding its balance sheet, and the tackling of the competitiveness problems of peripheral economies have hurt wage growth, consumption and imports. Meanwhile, exports have remained on a stable trend, thanks to both the comparative vigor of the euro area’s trading partners and a cheap euro. Therefore, net exports expanded. Capex benefited from the strength in European exports. A Granger causality test reveals that consumption has little impact on fixed-capital formation in the euro area. However, the same method shows that fluctuations in export growth cause changes in investment. This makes sense. The variance in exports is an important contributor to the variability of Eurozone profits (Chart 5). Thus, rising exports incentivize the European corporate sector to expand its capital stock to fulfill foreign demand. The expanding share of output created by exports and capex along with the role of exports as a driver of capex explains why Europe economic activity is bound to remain so sensitive to the fluctuations in global trade and manufacturing activity. Moreover, the capex/exports interplay even affects consumption. As Chart 6 shows, the growth of euro area personal expenditures often bottoms after the annual rate of change of the new orders of capital goods has troughed, which reflects the role of exports as a driver of European income. Chart 5Profits And Exports Chart 6Consumption Doesn't Move In A Vacuum Bottom Line: European economic activity remains a high beta play on global and Chinese growth. The decrease in consumption to the benefit of exports and capex explains why this reality will not change anytime soon. 2021, An Idiosyncratic Year? In 2021, consumption will be the key input to the European economic performance, despite the long-term relationship between European GDP and foreign economic activity. This will allow European growth to narrow some of its gap with the US and the rest of the world in the second half of this year and the first half of 2022, even if the global manufacturing sector comes off its boil soon. The 2020 recession was unique. In a normal recession, capex, real estate investment, spending on durable goods and the manufacturing sector are the main contributors to the decline in GDP. This time, consumption and the service sector generated most of the contraction in output. These two sectors also caused the second dip in GDP following the tightening of lockdown measures across Europe last winter. Once the more recent wave of lockdowns is behind us, consumption will most likely slingshot to higher levels. More than the US, where the economy has been partially open for months now, Europe remains replete with significant pent-up demand. Obviously, fulfilling this demand will require further progress in the European vaccination campaign, something we recently discussed. Chart 7The Money Supply Forecasts A Rapid Recovery The surge in M1 also points to a sharp rebound in consumption once governments lift the current lockdowns (Chart 7). M1 is a much more reliable predictor of economic activity in Europe than in the US, because disintermediation is not as prevalent in the Eurozone, where banks account for 72% and 88% of corporate and household credit, respectively, compared to 32% and 29% in the US. We cannot dismiss the explosion in the money supply as only a function of the ECB’s actions. European banks are in much better shape today than they were 10 years ago. Non-performing loans have been steadily decreasing. A rise in delinquencies is likely in the coming quarters due to the pandemic; however, the EUR3 trillion in credit guarantees by governments will limit the damages to the private sector’s and banking system’s balance sheets. Moreover, the Tier-1 capital ratio of the banking system ranges between 14% for Spain and 17% for Germany, well above the 10.5% threshold set by Basel-III (Chart 8). In this context, the pick-up in money supply mirrored credit flows. Thus, even if some of that credit reflects precautionary demand, the likelihood is high that a significant proportion of the built-up cash balances will find its way into the economy. Another positive sign for consumption comes from European confidence surveys. Despite tighter lockdown measures, consumer confidence has sharply rebounded, which historically heralds stronger consumption. Moreover, according to the ECB’s loan survey, stronger consumer confidence is causing an improvement in credit demand, which foreshadows a decline in savings intentions, especially now that wage growth is stabilizing (Chart 9). Nonetheless, there is still a risk that the advance in wages peters off. The recent wage agreement reached by Germany’s IG Metall union in North Rhine Westphalia was a paltry 1.3% annual pay raise, and once the Kurzarbeit programs end, the true level of labor market slack will become evident. However, for consumption to grow, all that we need to see now is stable wage growth, even if at a low rate.  Chart 8European Banks Are Feeling Better Chart 9Confidence Points To Stronger Consumption Beyond consumption, Europe’s fiscal policy will be positive compared to the US next year. The NGEU plan will add roughly 1% to GDP in both 2021 and 2022. As a result, the Eurozone’s net fiscal drag should be no greater than 1% of GDP next year. This compares to a fiscal thrust of -7% in the US in 2022, even after factoring in the new “American Jobs Act” proposed by the Biden Administration last week, according to our US Political Strategy team. Bottom Line: The revival in European consumption in the second half of 2021 and the first half of 2022 will allow the gap between European and global growth to narrow. This dynamic will be reinforced next year, when the fiscal drag will be lower in Europe than in the US. These forces will create a rare occasion when European growth will improve despite a deceleration (albeit a modest one) in global manufacturing activity. Investment Conclusions The continued sensitivity of the euro area economy to the global industrial and trade cycle indicates that over the long-term, European assets will remain beholden to the gyrations of global growth. In other words, the euro and European stocks will outperform in periods of accelerating global manufacturing activity, as they have done over the past 30 years. The next 12 to 18 month may nonetheless defy this bigger picture, allowing European assets to generate alpha for global investors. Chart 10The Euro Will Like Idiosyncratic European Growth First, the gap between US and euro area growth will narrow over the coming 12 to 18 months, thus the euro will remain well bid, even if the maximum acceleration in global industrial activity lies behind. As investors re-assess their view of European economic activity and the current period of maximum relative pessimism passes, inflows into the euro area will accelerate and the euro will appreciate (Chart 10). Hence, we continue to see the recent phase of weakness in EUR/USD as transitory. Second, European equities have scope to outperform US ones over that window. Some of that anticipated outperformance reflects our positive stance on the euro. However, a consumption-driven economic bounce will be positive for European financials as well. Such a recovery will let investors ratchet down their estimates of credit losses in the financial system. Moreover, banks are well capitalized, thus the ECB will permit the resumption of dividend payments. Under these circumstances, European banks have scope to outperform US ones temporarily, especially since Eurozone banks trade at a 56% discount to their transatlantic rivals on a price-to-book basis. An outperformance of financials will be key for Europe’s performance. Chart 11German/US Spreads Near Equilibrium? Finally, we could enter a period of stability in US/German yield spreads over the coming months. The ECB remains steadfast at limiting the upside in European risk-free rates, as Christine Lagarde reiterated last week. However, BCA’s US bond strategist, Ryan Swift, believes US yields will enter a temporary plateau, as the Federal Reserve will not adjust rates until well after the US economy has reached full employment. Hence, the Fed is unlikely to let the OIS curve bring forward the date of the first hike currently priced in for August 2022 on a durable basis, which also limits the upside to US yields. Thus, looking at core CPI and policy rate differences, US yields have reached a temporary equilibrium relative to Germany (Chart 11).   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial ##br##Conditions Chart 15Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It ##br##Once Was Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Highlights Extremely accommodative fiscal policy and a rapid pace of vaccination puts the US on track to close its output gap by the end of the year. The situation is different in Europe, and the euro area economy will likely continue to underperform the US until at least the summer. Investors are now unusually more hawkish than the Fed, whose caution is driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. The Fed’s rate projections, coupled with the extraordinary size of the American Rescue Plan, have stoked investor concerns about a significant rise in inflation. For inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. We expect a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. We recommend that investors maintain below-benchmark portfolio duration, and overweight US speculative over investment-grade corporate bonds. The fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar over the coming 0-3 months. But over a 6-12 month time horizon, we continue to favor global ex-US vs. US stocks, and expect the dollar to be lower than it is today. A Brighter Light At The End Of The Tunnel Chart I-1Even Better Than Some Optimists Would Have Predicted Over the past 4-6 weeks, the US has continued to make incredible progress in vaccinating its population against COVID-19. Chart I-1 highlights that the pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the US will have vaccinated 90% of its population by the end of September (if it is determined that the vaccine is safe to give to children). And these calculations assume the continuation of a two-dose regime, meaning that the eventual rollout of Johnson & Johnson's Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further. The situation is clearly different in Europe. The vaccination progress in several European countries is woefully behind that of the US and the UK (Chart I-2), and per capita cases in the euro area have again risen significantly above that of the US (Chart I-3). This reality motivated last week’s news that the European Union is reportedly planning on banning exports of the AstraZeneca vaccine for a period of time, as European policymakers grow increasingly concerned about the potential economic consequences of lengthened or additional pandemic control measures over the coming few months. Chart I-2Europe Is Badly Lagging The Vaccine Race… There was at least some positive economic news from Europe this month, as reflected by the flash manufacturing and services PMIs (Chart I-4). The euro area manufacturing PMI surpassed that of the US this month, reflecting that the prospects for goods-producing companies in Europe remain solidly linked to the strong global manufacturing cycle. Services, on the other hand, have been the weak spot in Europe, having remained below the boom/bust line since last summer (in contrast to the US). The March services PMI highlighted that this gap is now starting to narrow, although the euro area economy will likely continue to underperform the US until at least the summer. Chart I-3...And It Is Starting To Show Chart I-4Some Closure Of The Services Gap, But Still A Ways To Go   The underperformance of the European services sector over the past nine months has been due in part to more severe pandemic control measures, but also a comparatively timid fiscal policy. The IMF’s October Fiscal Monitor highlighted that the US had provided roughly eight percentage points more of GDP in above-the-line fiscal measures versus the European Union as a whole, and that was before the US December 2020 relief bill and this month’s $1.9 trillion American Rescue Plan (ARP) act were passed. The CBO estimates that the ARP will result in about US$1 trillion in outlays in 2021, which is roughly 5% of nominal GDP. Consequently, Chart I-5 highlights that consensus expectations now suggest that the output gap will be marginally positive by the end of the year, with the Fed’s most recent forecast implying that real GDP will be more than 1% above the CBO’s estimate of potential output. Chart I-5The US Output Gap Will Likely Be Closed By The End Of This Year The Fed Versus The Market Despite this, the Fed held pat during this month’s FOMC meeting and did not validate market expectations of rate hikes beginning in early 2023. Chart I-6 highlights the Fed funds rate path over the coming years as implied by the OIS curve, alongside the Fed’s median projection of the Fed funds rate. This means that investors are now more hawkish than the Fed, which is the opposite of what has typically prevailed since the global financial crisis. Chart I-6The Market Is Now, Unusually, More Hawkish Than The Fed Fed Chair Jerome Powell implied during the March 17 press conference that some FOMC participants were unwilling to change their projections for the path of interest rates based purely on a forecast, which argues that the median dot in the Fed’s “dot plot” will shift higher in the second half of the year if participants’ growth and inflation forecasts come to fruition. But Charts I-7A and I-7B suggest that the Fed’s caution is also driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. Chart I-7AA Positive Output Gap Implies… Chart I-7B…An Unemployment Rate Below NAIRU   The charts highlight the historical relationship between the output gap and the deviation of NAIRU from the unemployment rate, from 2000 and 2010. In both cases, the charts show that the unemployment rate would be below the CBO’s estimate of NAIRU at the end of this year (roughly 4.5%) given the CBO’s estimate for potential (i.e. full employment) GDP and the Fed's forecast for growth. However, the Fed is forecasting that the unemployment rate will essentially be at NAIRU, which is itself above the Fed’s longer-run unemployment rate projection of 4%. As such, the Fed does not see the unemployment rate falling to “full employment” levels this year, a precondition for the onset of rate normalization. Investors should note that the relationships shown in Charts I-7A and I-7B suggest that the unemployment rate will be closer to 3-3.5% at the end of this year if the Fed’s growth forecast is correct, which would constitute full employment based on the Fed’s 4% unemployment rate target. The difference between a 3-3.5% unemployment rate and the Fed’s estimate of 4.5% translates to a gap of roughly 1.5-2.5 million jobs at the end of this year, which underscores that the Fed expects either a significant shift in temporary to permanent unemployment or an influx of unemployed workers back into the labor force who don’t quickly find jobs once social distancing ends and pandemic restrictions are no longer required. Chart I-8The Full Employment Level Of GDP Has Not Been Significantly Revised There are three possible circumstances that would resolve this seeming contradiction. The first is that the Fed’s estimate for growth this year is simply too high, and that the output gap will be close to zero at the end of the year (i.e., more in line with consensus market expectations). The second is that the CBO is understating the level of GDP that is consistent with full employment, namely that potential GDP is higher than what they currently project. But Chart I-8 shows that the CBO’s current estimate for potential output at the end of this year is only 0.4% below what it had estimated prior to the pandemic, which is smaller than the positive gap implied by the Fed’s growth estimate for this year (roughly 1.2%). The third possibility is that the Fed is overestimating the extent to which the pandemic will cause permanent damage to the labor market. As we noted in our February report, even once social distancing is no longer required, it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). A gap of 1.5-2.5 million jobs accounts for roughly 10-15% of pre-pandemic employment in retail trade, or 4-7% of the sum of retail trade, leisure & hospitality, and other services. It is possible that permanent job losses or significantly deferred job recovery of this size will occur, but it is far from clear that it will. Were job losses / deferred jobs recovery of this magnitude to not materialize, it would suggest that the US will reach full employment earlier than the Fed is currently projecting, and would significantly increase the odds that the Fed will begin to taper its asset purchases and/or raise interest rates at some point next year – which is earlier than investors currently expect. For Now, Dangerously Above-Target Inflation Is Unlikely Fed projections of a 0% Fed funds rate for the next 2 1/2 years, coupled with the extraordinary size of the American Rescue Plan, have understandably stoked investor concerns about a significant rise in inflation. Larry Summers’ recent interview with Bloomberg was emblematic of the concern, during which he criticized the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 It is true that the Federal Reserve is explicitly aiming to generate a temporary overshoot of inflation relative to its target, the Biden administration’s fiscal plan is legitimately large, and there is a tremendous pool of excess savings that could be deployed later this year once the pandemic is essentially over. Clearly, the risks of overheating must be higher than they have been in the past. But from our perspective, out-of-control inflation over the coming 12-24 months would very likely necessitate one of two things to occur, and possibly both: US consumers decide to spend an overwhelmingly large amount of the excess savings that have been accumulated. Main street expectations for consumer prices rise sharply, prompted by a public discussion about the likelihood of a shifting inflation regime. Our view is rooted in the examination of the modern-day Phillips Curve that we presented in our January report, which considers both the impact of economic/labor market slack and inflation expectations as a driver of actual inflation. The modern-day Phillips Curve posits that expectations act as the trend for inflation, and slack in the economy determines whether actual inflation is above or below that baseline. Chart I-9 highlights that the output gap worked well prior to the global financial crisis at explaining the difference between actual and exponentially-smoothed inflation, the latter acting as a long-history proxy for expectations. Pre-GFC, the chart highlights that there have been only two exceptions to the relationship that concerned the magnitude rather than the direction of inflation. Post-GFC, the relationship deviated substantially, but in a way that implied that actual inflation was too strong during the last expansion, not too weak – particularly during the early phase of the economic recovery. This likely occurred because expectations initially stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation, but ultimately declined due to a persistently negative output gap as well as in response to the 2014 collapse in oil prices (Chart I-10). Chart I-9Pre-GFC, The Output Gap Generally Explained Inflation Surprises Chart I-10Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Thus, for inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. Chart I-11 highlights that the amount of excess savings that have accumulated as a percentage of GDP does indeed significantly exceed the magnitude of the output gap, but some of those savings have been and will be invested in financial markets (boosting valuation), some will be used to pay down debt, some will eventually be spent on international travel (boosting services imports), and some will likely be permanently held as deposits in anticipation of future tax increases. And while long-term household expectations for prices have risen since the passing of the CARES act last year, the rise has merely unwound the decline that took place following the 2014 oil price collapse (Chart I-12). Chart I-11A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent Chart I-12Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base   For now, this framework points to a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Investment Conclusions Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. While the Fed is likely to shift in a hawkish direction compared with its current projections, it is highly unlikely to become meaningfully more hawkish than current market expectations unless economic growth and the recovery in the labor market is much stronger than the Fed or the market is projecting. In fact, even if the market’s expectations for the first Fed rate hike shift to mid-2022 over the coming several months, Chart I-13 highlights that the impact on the equity market is likely to be minimal unless investors shift up their expectations for the terminal Fed funds rate. The chart presents a fair value estimate for the 10-year Treasury yield based on the OIS-implied path of the Fed funds rate out to December 2024, and assumes that short rates ultimately rise to the Fed’s long-term Fed funds rate projection of 2.5%. The second fair value series assumes that the shape of the OIS curve stays the same, but shifts closer by 6 months. Chart I-13The Market’s Assumed Rate Hike Path And Terminal Rate Are Not Threatening For Stocks The chart underscores that the 10-year yield will rise to at most between 2-2.2% by the end of the year based on these scenarios. A shift forward in the timing of Fed rate hikes will impact the short end of the curve, but the long end will remain relatively unchanged if terminal rate expectations stay constant and the term premium on long-term bonds remains near zero. These levels would in no way be economically damaging nor threatening to stock market valuation. It is possible, however, that investor expectations for the neutral rate of interest (“r-star”) will shift higher once the pandemic is over, and we explore this risk to stocks in Section 2 of our report. For now, this remains a risk to our view rather than our expectation, but it is likely to remain an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Within fixed income, we recommend that investors maintain below-benchmark portfolio duration even though investors are already pricing in a more hawkish path for the Fed funds rate. First, Chart I-13 highlighted that yields at the long end of the curve are likely to continue to move modestly higher this year even if the projected path for the Fed funds rate remains relatively unchanged. But more importantly, barring a substantially negative development on the health or vaccine front that prolongs the pandemic, the risk appears to be clearly to the upside in terms of the timing of the first Fed rate hike and the terminal Fed funds rate. As such, from a risk-reward perspective, a long duration stance remains unattractive. We would also recommend overweighting US speculative over investment-grade corporate bonds, as spreads are not as historically depressed for the former than the latter (Chart I-14). Finally, in terms of the dimensions of equity market performance and the dollar, we recommend that investors overweight global ex-US equities vs. the US, overweight value vs. growth, overweight cyclicals vs. defensives, and overweight small vs. large caps. We are also bearish on the dollar on a 12-month time horizon. However, there are two caveats that investors should bear in mind. First, global cyclicals versus defensives (especially in equally-weighted terms) as well as small versus large caps have already mostly normalized not just the impact of the pandemic but as well that of the 2018-2019 Trump trade war (Chart I-15). We would expect, at best, modest further gains from both positions this year. Chart I-14Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Chart I-15Going Forward, Expect More Modest Gains From Cyclicals And Small Caps   Second, the fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar on a 0-3 month time horizon. The US dollar is typically a counter-cyclical currency, but there have been exceptions to that rule. And historically, exceptions have tended to revolve around periods when US growth has been quite strong, as is currently the case (Chart I-16). A continued counter-trend rally in the dollar is thus possible over the course of the next few months, but we would expect USD-EUR to be lower than current levels 12 months from now. Chart I-16A Short-Term Counter-Trend Dollar Move Is Possible A counter-trend dollar move could also correspond with a period of US outperformance versus global ex-US, or at a minimum, a period of flat performance when global ex-US stocks would normally outperform. Our China strategists expect that the Chinese credit impulse will decelerate later this year (Chart I-17), which would weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. Chart I-18 highlights that euro area equity underperformance versus the US last year was mostly a tech story, but today there is little difference between the relative performance of euro area stocks overall versus indexes that exclude the broadly-defined technology sector. In both cases, the euro area index is roughly 10% below its US counterpart relative to pre-pandemic levels, which exactly matches the extent to which euro area financials have underperformed. Chart I-17A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform Chart I-18Euro Area Financials Need To Outperform For Europe To Outperform   Euro area financials have demonstrated very poor fundamental performance over the past decade, but they are likely to outperform for some period once the European vaccination campaign gains enough traction to alter the disease’s transmission and hospitalization dynamics. Chart I-19 highlights that euro area bank 12-month forward earnings have further room to recover to pre-pandemic levels than for banks in the US, and Chart I-20 highlights that euro area banks trade at their deepest price-to-book discount versus their US peers since the euro area financial crisis. Chart I-19Euro Area Bank Earnings Have Catch-Up Potential Chart I-20Euro Area Banks Are Extremely Cheap Versus The US   Thus, while euro area and global ex-US equities may not outperform on the back of rising global stock prices over the coming few months, investors focused on a 6-12 month time horizon should respond by increasing their allocation to European stocks and to further reduce dollar exposure. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst March 31, 2021 Next Report: April 29, 2021 II. R-star, And The Structural Risk To Stocks In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,2 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have ticked slightly lower from their strongest levels on record. Within a global equity portfolio, US stocks have recently risen versus global ex-US, reflecting a countertrend rise in the US dollar and a lagging vaccination campaign in Europe. We expect a deceleration in the Chinese credit impulse later this year, which will weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. The US 10-Year Treasury yield has risen well above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields could move higher over the cyclical investment horizon. The recent bounce in the US dollar has reflected improved relative US growth expectations, but also previously oversold levels. The dollar may continue to strengthen on a 0-3 month time horizon, but we expect it to be lower in 12 months’ time than it is today. Commodity prices have recovered not just back to pre-pandemic levels, but also back to 2014 levels. This underscores that many commodity prices are extended, and may be due for a breather once the Chinese credit impulse begins to decline. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. This underscores that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial Conditions Chart 15Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It Once Was Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance  

Highlights Duration & The Fed: Unlike the bond market, the Fed is being intentionally cautious about how quickly it revises its interest rate expectations higher, focusing more on hard economic data than on surveys. We expect the Fed dots to move up later this year as the hard economic data improve, validating current pricing in the bond market. Maintain below-benchmark portfolio duration. Yield Curve: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up. Feature The pain in the bond market continues. The 10-year Treasury yield rose again last week, closing at 1.74% on Friday, and the Bloomberg Barclays Treasury Index has now returned -6.1% since it peaked last August. If we use the peak-to-trough drawdown in the Treasury Index as our gauge, we are now in the midst of one of the five worst bond selloffs of the past 50 years. During that 50-year period, the current bearish bond move is only surpassed by the 2009, 2003, 1994 and 1980 episodes (Chart 1). Chart 1A Historic Bond Rout That said, the current bond selloff might still have a lot of runway. In level terms, the 30-year Treasury yield has only just recaptured its 2020 peak and the 10-year yield hasn’t even done that (Chart 2). Then, there’s another 101 bps of upside in the 30-year yield and 150 bps of upside in the 10-year yield just to get back to their 2018 peaks, yield levels that aren’t exactly distant memories. Yields do look stretched if we look at long-dated forwards. The 5-year/5-year forward Treasury yield, for example, is already well above its 2020 peak. The large increase in the 5-year/5-year forward yield is the result of Fed policy keeping the short-end of the yield curve capped (Chart 2, bottom 2 panels) forcing the bulk of Treasury weakness to be felt at the long-end. The 5-year/5-year forward Treasury yield is important because it reflects the market’s expectation of where the fed funds rate will settle in the long-run. In fact, you can use survey estimates of the long-run neutral fed funds rate to get a useful fair value range for the 5-year/5-year forward. At present, the 5-year/5-year forward yield has pushed well above this survey-derived fair value range (Chart 3), though it’s important to note that it is still 75 bps below its 2018 peak. Survey estimates of the long-run neutral fed funds rate were revised down as growth disappointed in 2019, it stands to reason that they could be revised higher as growth improves this year, thus moving the fair value range up as well. Chart 2Yields Can Rise Further Chart 35-Year/5-Year Is Elevated In fact, whether that process of upward revisions to survey estimates of the long-run neutral fed funds rate begins is an important near-term question for the bond market. Upward revisions would signal further upside in long-dated yields and more curve steepening ahead. Static long-run neutral rate estimates would signal that the upside in long-maturity yields is limited. In that latter case, the cyclical bond bear market would transition to a less severe bear-flattening phase where short-maturity yields eventually catch up to the long-end as the Fed tightens policy. It’s currently unclear how those survey estimates will evolve – we will get March updates for both surveys shown in Chart 3 on April 8th – but for now it’s too soon to say that the 5-year/5-year forward yield has peaked. We continue to recommend maintaining below-benchmark portfolio duration as we keep tabs on our Checklist To Increase Portfolio Duration.1 Currently, our Checklist is not screaming out for us to make a change. Explaining The Disagreement Between The Fed And The Market We expected that Fed policymakers would revise up their interest rate forecasts at last week’s FOMC meeting, but we also expected that the forecasts wouldn’t rise far enough to match the rate hike path that is currently priced in the market.2 This is in fact what happened, though the Fed was slightly more dovish than we anticipated. Only 7 out of 18 FOMC participants expect any rate hikes at all before the end of 2023, while the overnight index swap curve is discounting more than four 25 basis point hikes by then (Chart 4). Chart 4Market More Hawkish Than Fed What explains this divergence between the market and the Fed? Perhaps bond investors are simply ignoring the Fed’s dovish message. In that case, we should expect yields to fall as it becomes clear that the Fed intends to keep rates pinned at zero for much longer than is currently priced in the curve. Or perhaps Fed policymakers just don’t appreciate the surge in economic activity that is about to unfold. In that case, their interest rate forecasts (the “dots”) will rise sharply in the coming months as the economic data improve. Chair Powell gave a hint about how we should think about the divergence between the market and the “dots” in his post-meeting press conference. He said that the Fed wants to see “actual progress” towards its economic objectives not “forecast[ed] progress”, and he noted that this increased focus on “actual progress” is “a difference from our past approach.”3 In other words, the Fed is making a concerted effort to take a more backward-looking approach to policymaking under its new Average Inflation Targeting regime. It doesn’t want to tighten policy in response to a forecast of stronger growth in the future only to get whipsawed if that forecast doesn’t pan out. It would rather err on the side of tightening too late and then possibly have to move more quickly if it falls behind the curve. The market, by contrast, is a purely forward-looking discounting mechanism. Market prices move quickly to incorporate new information but are often caught offside. We are reminded of Paul Samuelson’s famous quip that the stock market has predicted nine of the past five recessions. This explains exactly what is happening right now. The market is looking ahead, taking its cues from survey data (or “soft data”) such as the ISM indexes that are pointing toward a sharp rise in economic activity and inflation. The Fed, by contrast, is endeavoring to focus more on the actual hard economic data such as the unemployment rate, industrial production and consumer price indexes. These hard economic data simply haven’t improved that much yet. The last section of this report (titled “Economy: Hard Vs Soft Data”) gives some examples of how the hard and soft economic data have diverged. Chart 5The Path Back To Maximum Employment Ultimately, the disagreement between the market’s funds rate expectations and the Fed’s dots will be resolved as the hard economic data are released during the next few months. Those data will either validate the current message from economic surveys, causing the Fed to revise up its rate forecasts, or disappoint market expectations, causing market forecasts and bond yields to fall. In this regard, the hard economic data on the labor market will be particularly important. The Fed has said that it will not lift rates until “maximum employment” is achieved. In practice, “maximum employment” means that the unemployment rate will fall into a range of 3.5% - 4.5%, consistent with the Fed’s estimates of the natural rate, and the labor force participation rate will recover to pre-COVID levels (Chart 5). The top row of Table 1 shows that average monthly employment growth of 419k is required to achieve that target by the end of 2022. We have made the case in prior reports that, though that number seems high, it is achievable.4   Table 1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date It’s also worth noting that the Fed’s median unemployment rate forecast was revised significantly lower last week. The Fed is now looking for an unemployment rate of 4.5% by the end of this year and 3.9% by the end of 2022 (Chart 5, top panel). The fact that the Fed doesn’t project any rate hikes during this timeframe can only mean that policymakers aren’t forecasting a similar recovery in the labor force participation rate. The bottom line is that, unlike the market, the Fed is being intentionally cautious about how quickly it revises its funds rate expectations higher, focusing more on hard economic data than surveys. Eventually, the disagreement between the hard and soft economic data will be resolved and either the Fed dots will move toward the market, or the market will move toward the Fed. Our sense is that the Fed is probably being overly cautious and that their forecasts will eventually move toward the market, validating current bond yields. Too Early To Expect Curve Flattening We have been recommending nominal Treasury curve steepeners for some time, on the view that the yield curve will trade directionally with yields. This means that rising yields will coincide with curve steepening.5 This correlation has held up extremely well, but we know that it won’t last forever. Eventually, we will be close enough to Fed rate hikes that the yield curve will start to flatten as yields rise. This process will begin at the long-end of the curve and gradually shift toward the short-end as Fed liftoff approaches. Chart 6 shows how the correlation between the level of Treasury yields and different yield curve slopes has held up during the recent surge in bond yields. For the most part, the tight correlation between rising yields and steeper curves remains intact, with the 10/30 slope being the exception (Chart 6, bottom panel). It looks like during the past month the 10/30 slope has transitioned from a bear-steepening/bull-flattening regime into a bear-flattening/bull-steepening regime. The investment implication is that the short position of a curve steepener trade should be applied to the 10-year note not the 30-year bond, particularly for duration-neutral steepeners. It’s difficult to know exactly when the other segments of the yield curve will transition from their bear-steepening/bull-flattening regimes into bear-flattening/bull-steepening regimes, but we suspect that the current correlations have quite a bit more running room. If we look at what occurred prior to the last time that the Fed lifted rates off the zero bound, in December 2015, we see that most curve segments didn’t start to bear-flatten until a few months before liftoff (Chart 7) Chart 6Bear-Steepening/Bull-Flattening Regime Continues Chart 7Bear-Flattening Started Just Months Before 2015 Liftoff In terms of how to implement a yield curve steepener, we have been recommending a position long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. We are sticking with that position for now, as it has performed well even as the 2/5/10 butterfly spread has widened in recent weeks (Chart 8). We expect it will continue to perform well as long as both the 2/5 and 5/10 yield curve slopes continue to steepen. Once we suspect that the 5/10 slope is transitioning into a bear-flattening/bull-steepening regime, we will have to either shift into a curve flattener or a curve steepener that is focused more at the short-end of the curve. Chart 85/10 Slope Still Steepening Bottom Line: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: Hard Vs. Soft Data Chart 9IP Lags The PMI Chart 10Surveys Suggest Higher Inflation Ahead As noted above, the US economy is at an interesting inflection point where, owing to large-scale fiscal stimulus and an effective COVID vaccination rollout, there is a lot of optimism about the future. This optimism is showing up in how people respond to surveys about their economic and business expectations, but it has not yet translated into better actual economic outcomes. The ISM Manufacturing PMI survey is a case in point. It surged to 60.8 in February, its highest level since 2018, but actual measured industrial production continues to contract in year-over-year terms (Chart 9). In all likelihood, this is simply a result of surveys (“soft data”) leading the hard data. A simple linear regression fit between industrial production and the PMI shows that wide negative divergences have a habit of showing up during recessions, only for the gaps to close very quickly in the early stages of the recovery. We see the same dynamic at play in the inflation data. Actual core CPI inflation has not moved up significantly, but surveys indicate that price pressures are rising fast (Chart 10). Bottom Line: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on our Checklist please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210317.pdf 4 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Recent Changes Lock in gains of 4.3% and downgrade the S&P construction machinery & heavy trucks index to neutral, today. Table 1​​​​​​​ Feature While the Fed’s dots dovishly surprised market participants last week, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s 2021 core PCE price inflation estimate to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. Clearly, the Fed is in a bind as it tries to strike a delicate balance between short and long term rates. Our thesis, first posited on February 1, remains that the bond market will keep on testing the Fed’s resolve until the FOMC members start to “talk about talking about tapering”. An economy running on steroids buoyed both by ultra loose monetary and fiscal policies at a time when it is primed to reopen at full speed around Memorial Day is inherently inflationary. Under such a backdrop, the subsurface equity market’s response makes perfect sense. “Back-To-Work” stocks left “COVID-19 Winners” in the dust, small caps outperformed the Nasdaq 100, the Value Line Arithmetic Index and the RVRS1 exchange traded fund outshone the SPX and the S&P 495 trounced the S&P 5 (Chart 1). In other words, when growth is scarce as during last year’s recession investors flock to growth stocks, now that growth is abundant investors are cornering value stocks with the highest degree of operating leverage (top panel, Chart 1). While this deck reshuffling may go on temporary hiatus as the 10-year US Treasury yield pauses for breath, this sector rotation has cyclical staying power. Given this looming inflationary impulse context, today we update our Corporate Pricing Power Indicator (CPPI). Chart 2 shows that our CPPI has swung over 10 percentage points from the recent trough, accelerating north of 5%/annum pace. In fact, our diffusion index of the 60 selling price categories we track has vaulted to all-time highs (second panel, Chart 2). Chart 1Anatomy Of The Market Chart 2Corporate Pricing Power Flexing Its Muscles Wage inflation is also coming out of hibernation, with job switchers outpacing job stayers’ salary inflation, according to the latest Atlanta Fed wage growth trackers (third panel, Chart 2). Importantly, the most recent NFIB survey showed that small businesses have the hardest time filling job openings by finding qualified labor. Over the past three decades, this backdrop has been conducive to wage inflation (Chart 3), and if history at least rhymes, a pick-up in wage inflation is in the cards in the back half of the year (Chart 4). Our sense is that the economic reopening will by then be at full speed, further exacerbating wage pressures. Chart 3Inflation… While profit margins are on the cusp of shaking off the remnants of the COVID-19 accelerated recession, sell-side analysts’ 12-month forward profit margin estimates show no signs of input cost pressures, at least not yet. The risk is that corporations may find it challenging to pass on these looming wage increases down the supply chain and all the way to the consumer in order to preserve margins (bottom panel, Chart 2). The jury is still out on who will eventually have to bear the brunt of inflationary pressures, especially in the context of rising fiscal deficits (i.e. personal current transfers). Drilling beneath the surface, our CPPI signals that genuine inflationary pressures are mounting as supply chains are strained causing shortages on a slew of manufacturing industries. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 4…Is Coming Table 2Industry Group Pricing Power While 68% of the industries we cover are outright lifting selling prices, half are doing so at a faster clip than overall inflation. With regard to pricing power trends, encouragingly only 30% of the industries we cover are in a downtrend (Table 2). Services industries mostly populate the bottom half of Table 2 with the usual suspects – airlines, air freight, hotels and movies & entertainment – that COVID-19 wreaked the most havoc to occupying the bottom four spots. Nevertheless, this is looking in the rearview mirror. The tide is slowly turning as a recent update from the TSA highlighted that passenger enplanements are perking up. Lumber has reached escape velocity and has sustained forest products atop our table with a meteoric year-over-year growth rate of 149%! Commodities populate nine out of the top ten spots and while gold has fallen down the ranks since our last update, it is still expanding at a near 10%/annum rate, despite the greenback’s year-to-date rise. Energy related commodities are on fire and peak oil inflation will hit in April/May due to base effects. Keep in mind that last spring WTI crude oil prices sank into a deeply negative print per bbl. While at first sight all seems upbeat in the commodity complex, beneath the surface some cracks are forming. This week, we revisit our number one macro risk for the back half of the year: China’s pending slowdown, and downgrade a deep cyclical capital goods sub-group to neutral. Gauging China’s Slowdown Cresting in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel, Chart 5), and now we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel, Chart 5), and the near-term risk is that the S&P 500 may be next in line (top panel, Chart 5), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Taking cue from Chinese financial market data is also instructive. The MSCI China stock price index, its short-term momentum, net EPS revisions and 12-month forward EPS growth all troughed last spring. It is slightly unnerving that by all these metrics China’s stock market recovery is coming off the boil and may be a precursor to a soft-patch in the coming months (Chart 6). Chart 5Monitor China Closely Chart 6What Are Chinese Stocks Sniffing Out? Importantly, select commodities, especially ones that are hypersensitive to Chinese activity, appear exhausted and have likely hit, at least a temporary, zenith. While anecdotes of metal related scams and thefts are mushrooming especially catalytic converters mostly owing to rare earths soaring prices, we would not be surprised were bronze/copper statues to start disappearing and sold for scrap, as was prevalent in the mid-2000s commodity super cycle. Dr. Copper has more than doubled in the past year, is near all-time highs and already discounts a lot of good China recovery news (top panel, Chart 7). Historically, Google Trends searches for “commodity super cycle” have been closely correlated with cyclicals/defensives relative performance and the recent spike near all-time highs likely corroborates that the Chinese recovery is well advanced (Chart 8). Chart 7Glass Ceiling Chart 8“Commodity Super Cycle” Hubris? WTI crude oil prices have also jumped over $100/bbl after hitting the negative $37/bbl mark last April. In the mid-60s/bbl crude oil has likely hit a ceiling and will have a tough time surging past this long term resistance. Sentiment is as extreme as it was during the Desert Storm in the early 1990s, which is the last time the oil RSI jumped over 80 (Chart 9)! Chart 9Slippery Slope? The Australian dollar, a commodity currency levered to China’s wellbeing, has also been on a tear since last March with AUDUSD rising from 0.55 to roughly 0.80. The Aussie is currently at the upper band of its range, since the Hawke/Keating government floated it in 1983, and facing stiff resistance. There are rising odds that AUDUSD is also sniffing out some China softness in the coming months (bottom panel, Chart 7). Finally, Chinese surveys and money aggregates data also signal that a garden variety slowdown will take root, especially post the 100-year Communist Party anniversary this summer. The Chinese manufacturing PMI is awfully close to the 50 expansion/contraction line, at a time when both M1 money supply has ticked lower and the total social financing impulse has rolled over (Chart 10). Tack on our sister’s China Investment Strategy’s recent estimate of a further steep deceleration in the latter and factors are falling into place for an engineered slowdown in China in the back half of the year (bottom panel, Chart 10). Bottom Line: China is on the cusp of a slowdown, remains a key macro risk to monitor, and thus we use this opportunity to book gains in a deep cyclical industrials sub-group and downgrade to neutral. Chart 10Keep Your China Guard Up CAT Stalling? As China’s economic growth downshifts, we are compelled to book gains in machinery stocks and downgrade to neutral. This sub-surface industrials sector move comes on the heels of last week’s upgrade in the more domestically focused railroads, and does not affect the broad sector’s overweight stance. First, machinery stocks are extremely overbought by historical standards outpacing the SPX by 36% on a year-over-year basis. Valuations have also spiked: the relative price to sales ratio is back near par and trades at a 25% premium to the historical average (Chart 11). Such lopsided positioning is fraught with danger and could at least temporarily reverse in a violent fashion. Second, while the US dollar has been boosting the industry’s exports and adding to machinery P&L via positive translation gains, the greenback’s year-to-date appreciation will eat into profits, at the margin, in the back half of the year (second & middle panels, Chart 12). Chart 11Too Far Too Fast Chart 12First Signs Of Cracks Appearing Sell-side analysts have taken notice and net profit revisions have topped out. Similarly, our EPS growth macro models suggest that machinery stocks will struggle to outearn the SPX (Chart 12). Lastly, as China goes, so go machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (fourth panel, Chart 12). Tack on the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the outlook for machinery end-demand darkens further (Chart 13). Nevertheless, before getting outright bearish on machinery stocks, there are a few offsetting factors. Commodity prices, while toppy, remain firm, and alleviate fears of a severe Chinese slowdown. Moreover, Chinese excavator sales are on a tear surging to a three year high. While China’s manufacturing PMI has petered out, both the global PMI and developed market PMIs are reaccelerating. As the global economy reopens, services PMIs will further boost the global composite PMIs (second & bottom panels, Chart 14). Chart 13Chart Of The Year Candidate Finally, while our relative EPS growth models hover near the zero line, the same is also true for the sell side’s profit growth estimates and represent a modest hurdle for the industry to surpass (third panel, Chart 14). Netting it all out, China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Chart 14Reasons Not To Turn Outright Bearish Bottom Line: Downgrade the S&P construction machinery & heavy trucks index to neutral today for a relative gain of 4.3% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     The Reverse Cap Weighted U.S. Large Cap ETF (Ticker: RVRS) provides exposure to the companies in the S&P 500 index. However, while traditional market cap weighted indexes such as the S&P 500 weight companies inside the index by their relative market capitalization, RVRS does the opposite, weighting companies by the inverse of their relative market cap. By investing smallest-to-biggest, the fund is tilting investment exposure to the smaller end of the market cap spectrum within the large cap space. https://exponentialetfs.com/wp-content/uploads/2021/01/Reverse-ETF-Factsheet_2020.12.311.pdf Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 ​​​​​​​Favor value over growth

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Thursday, March 25 at 10:00 am EDT and Friday March 26 at 9:00 am HKT. I look forward to your comments and questions during the webcast. Best regards, Chester Highlights During bear markets, counter-trend rallies in the dollar are capped around 4%. This time should be no different. Meanwhile, unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real short rates will drop. The relative equity performance of the US is critical for the dollar. Reserve diversification out of dollars has also started to place a natural ceiling against other developed market currencies. An attractive opportunity is emerging to short the AUD/CAD cross. Feature The 1.7% rise in the US dollar this year is reinvigorating the bull case. When presenting our key views last year, we highlighted that the DXY index was at risk of a 2-4% bounce.1 We reaffirmed this view in our January report: Sizing A Potential Dollar Bounce. At the time, the DXY index was at the 90 level, suggesting the rally should fizzle around 94. Therefore, the key question is whether the nascent rise in the DXY will punch through this level, or fade as we originally expected. The short-term case for the dollar remains bullish. The currency is much oversold. Meanwhile, real interest rates are moving in favor of the US, vis-à-vis a few countries. Third and interrelated, economic momentum in the US is quite strong, compared to other G10 countries. With the rising specter of a market correction, the dollar could also benefit from safe haven flows towards the US. The Federal Reserve’s meeting yesterday certainly reaffirmed that short-term rates will remain anchored near zero, at least until 2023. The Fed does not see inflation much above 2% a couple of years out. Nevertheless, a lot can change in the coming months. Cycles, Positioning And Interest Rates The dollar tends to move in long cycles, with the latest bull and bear markets lasting about a decade or so. In other words, the dollar is a momentum currency. As such, determining which regime you are in is critical to assessing the magnitude of any rally. This is certainly the case when sentiment remains overly dollar bearish, as now. During bear markets, counter-trend rallies in the dollar are capped around 4-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-1). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-1The Dollar Rally Is Still Benign Long interest rates have also been moving in favor of the dollar, especially relative to the euro area, Japan, and even Sweden. Currencies are driven by real interest rate differentials, and higher US yields are bullish. With the Fed giving no indication it will prevent the curve from steepening further, US interest rates could keep gaping higher. However, currencies are about relative rate differentials, and the rise in US interest rates has not been in isolation. Rates in the UK, Australia and New Zealand, countries that have managed the COVID-19 crisis pretty well, are beginning to rise faster than in the US (Chart I-2). Chart I-2A Synchronized Rise In Global Yields US Versus World Growth The rise in US interest rates has been justified by better economic performance. Whether looking at purchasing managers’ indices, economic surprise indices, or even GDP growth expectations, the US has had the upper hand (Chart I-3). The Fed expects US growth to hit 6.5% this year. This is well above what other central banks expect for their domestic economies. The ECB expects 4%, the BoJ expects 3.9%, and the BoC expects 4.6% (Table I-1). Chart I-3AThe US Leads In Growth This Year Chart I-3BThe US Leads In Growth This Year Table I-1The US Leads In Growth And Inflation This Year However, economic dominance can be transient, especially in a world of flexible exchange rates.  For one, a higher dollar will sap US growth via the export channel. This is especially the case since the starting point is an expensive currency. On a real effective exchange rate basis, the dollar is above its long-term mean (Chart I-4). Meanwhile, we expect the rest of the world to perform better as economies reopen. The services PMI in the US is already close to a cyclical high, similar to Sweden (Chart I-5). These are among the countries with the least stringent COVID-19 measures in the western hemisphere. This suggests that other economies, even manufacturing-centric ones, could see a coiled-spring rebound in growth as we put this pandemic behind us. Chart I-4The Dollar Is Expensive Chart I-5The US Service PMI Is At A Cyclical High The sweet spot for most economies is when growth is rising but inflation is low, allowing the resident central bank to keep policy dovish. However, it is an open question if the US can continue to boost spending, without a commensurate rise in inflation. The OECD estimates that the US output gap will close by 2022, with the $1.9-trillion fiscal package. This will put the US well ahead of any G10 country (Chart I-6). Unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real rates will drop (Chart I-7). Rising nominal rates and falling real yields will be anathema to the dollar. Chart I-6The US Output Gap Will Soon Close Chart I-7Wages And Inflation Should Inch Higher Equity Rotation And The Dollar A currency manager once noted that the most important variable to pay attention to when making FX allocations is relative equity performance. This might seem bizarre at first blush, but stands at the center of what an exchange rate is – a mechanism that equalizes rates of return across countries. As such while bond flows are important for exchange rates, equity flows matter as well. The relative equity performance of the US is critical for two reasons. First, the US equity market tends to do relatively better during bear markets. This was the case last year and during the 2008 crisis. Second, the outperformance of the US over the last decade has dovetailed with a dollar bull market (Chart I-8). It is rare to find a currency that has performed well both during equity bull and bear markets. If past is prologue, the near-term risks for the dollar are to the upside, especially if the market rally encounters turbulence as yields rise. The put/call ratio in the US is at a 5-year nadir. A move towards parity could violently pull up the DXY index (Chart I-9). However, a garden-variety 5-10% correction in the SPX should correspond to a shallow bounce in the DXY. This will also fit the pattern of bear market USD rallies, as we already highlighted in Chart I-1. Chart I-8US Equity Relative Performance And The Dollar Chart I-9The Dollar Could Rise In ##br##A Market Reset At the same time, any correction could usher in a violent rotation from cyclicals to defensives, especially if underpinned by higher interest rates. The performance of energy and financials are a leap ahead of other sectors in the S&P 500 this year. Importantly, they also massively outperformed during the February drawdown. Meanwhile, valuations are heavily elevated in the US compared to the rest of the world. This is true for growth sectors compared to value, and cyclicals compared to defensives. Throughout history, both exchange rates and valuations have tended to mean revert. Long-Term Dollar Outlook The 2020 pandemic was a one-in-a-hundred-year event. Coordinated fiscal and monetary stimuli have ushered in a new economic cycle. As a counter-cyclical currency, the dollar tends to do poorly (Chart I-10). This is because monetary stimulus provides more torque to economies levered to the global cycle. Once growth achieves escape velocity, the currencies of these more pro-cyclical economies benefit. The IMF projects that non-US growth should outpace US growth after 2021. Meanwhile, it is an open question that any rally in the dollar will be durable. The key driver behind the dollar increase in 2020 was a global shortage. Not only has the Fed extended its liquidity provisions to foreign central banks until September this year, the share of offshore US dollar debt issuance has fallen by a full 9 percentage points (Chart I-11). Simply put, the Fed is flooding the system with dollar liquidity at the same time that foreign entities are weaning themselves off it Chart I-10The IMF Expects Faster Growth Outside The US After 2021 Chart I-11Share Of US Dollar Debt ##br##Rolling Over The reason behind this is balance-of-payment dynamics. The market has realized that ballooning twin deficits in the US come at a cost. For foreign issuers, it is the prospect of rolling over US-denominated debt at a much higher coupon rate. For bond investors, it is currency depreciation, especially if fiscal largesse becomes too “sticky,” and stokes inflation. As such, bond investors continue to avoid the US, despite rising rates (Chart I-12). Finally, reserve diversification out of dollars has started to place a natural ceiling on the US dollar, especially against other developed market currencies. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart I-13). This will place a durable floor under developed market currencies in general and gold in particular. The Chinese RMB has also been gaining traction in global FX reserves. Chart I-12Little Appetite For US ##br##Treasurys Chart I-13Reserve Diversification Has Been A Headwind For The Dollar More specifically, the role of the USD/CNY exchange rate as a key anchor for emerging market currencies will rise, especially if the RMB remains structurally strong.2 The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. Swap agreements entail no exchange of currency, but are about confidence. The PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves. The dollar will remain the global reserve currency for years to come. However, a slow pivot towards reserve diversification will act as a structural headwind for the dollar. Housekeeping Chart I-14AUD/CAD Is Correlated To The VIX We were stopped out of our CAD/NOK trade for a profit of 3.1%. The resilience of the US economy is benefiting the CAD more than the NOK for now. However, the Norges Bank confirmed it might be one of the first central banks to lift rates, as early as this year. We are both short USD/NOK and EUR/NOK and recommend sticking with these positions. Second, the growing spat between the EU and the UK could lead to more volatility in our short EUR/GBP position. Our target remains 0.8, but we are tightening stops to 0.865 to protect profits. The BoE left interest rates unchanged, but struck a constructive tone. This will bode well for cable, beyond near-term volatility. Third, our short USD/JPY position was stopped out amid the dollar rally. We are standing aside for now, but will reopen this trade later. Finally, a rise in volatility will boost the dollar, but also benefit short AUD/CAD positions. We are already short the AUD/MXN, but short AUD/CAD could be more profitable should market turmoil persist (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see the Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020. 2 Please see Foreign Exchange Strategy Currency In-Depth Report, titled “Will The RMB Continue To Appreciate?,” dated February 26, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Most data out of the US has been robust: Both PPI, import and export prices were in line with expectations for February. The PPI ex food and energy came in at 2.5% year-on-year. Empire manufacturing was robust at 17.4 in March, versus 12.1 last month. Housing starts and building permits came in a nudge below expectations in February, at 1421K and 1682K. The one disappointment was retail sales, which fell 3.3% year-on-year in February. The DXY index rose slightly this week. The FOMC remained dovish, without any revision to its median path of interest rate hikes. The markets disliked its reticence on rising long-bond yields. As such, equities are rolling over as yields continue to creep higher. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area are mending: The ZEW expectations survey rose to 74 in March, from 69.6. For Germany, the improvement was better at 76.6 from 71.2. The trade balance remained at a healthy €24.2bn euro surplus in January. The euro fell by 0.6% amidst broad dollar strength. With the ECB committed to cap the rise in yields and rise in peripheral spreads, relative interest rates will move against the euro. Sentiment remains elevated, and so a healthy reset is necessary to wash out stale longs. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been mixed: Core machinery orders grew 1.5% year-on-year in January. Exports fell by 4.5% in January, while imports rose by 11.8%. This has shifted the adjusted trade balance to a deficit of ¥38.7bn yen. The Japanese yen fell by 0.4% against the US dollar this week, and remains the weakest G10 currency this year. Rising yields have seen Japanese investors stampede into overseas markets such as the UK, while pushing down the yen. We remain yen bulls, but will stand aside for now since it could still go lower in the short term. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been weak: Industrial production and construction output fell by 4.9% and 3% year-on-year in January. Monthly GDP growth fell by 2.9% in January. Rightmove house prices rose 2.7% year-on-year in March. The pound fell by 0.4% against the dollar this week. It however remains the best performing currency this year. The BoE kept monetary policy on hold, but struck a hawkish tone as vaccination progresses, giving way to higher mobility in the summer. We remain long sterling via the euro. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home prices rose by 3.6% in the fourth quarter. Modest home appreciation is welcome news by the RBA, given high-flying prices in its antipodean neighbor. The employment report was solid. There were 88.7K new jobs in February, all full-time. This pushed down the unemployment rate to 5.8% from 6.4%. The Aussie fell by 0.4% this week. The Australian recovery is fast approaching escape velocity, forcing the RBA to contain a more pronounced rise in long-bond yields. We remain long AUD/NZD. In the very near term, a market shakeout could pull the Aussie lower, favoring short AUD/CAD positions.  Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data out of New Zealand was weak: Credit card spending fell by 10.6% year-on-year in January. Q4 GDP contracted by 1% both year-on-year and quarter-on-quarter. The current account remains in deficit at NZ$-2.7bn for Q4. The New Zealand dollar fell by 0.9% against the US dollar this week. The new rule to include house prices in setting monetary policy will be a logistical nightmare for the RBNZ. In trying to achieve financial stability, the RBNZ will have to forego some economic stability, especially if the country still requires accommodative settings. Confused messaging could also introduce currency volatility. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 There was a data dump in Canada this week: The economy added 259.2K jobs in February. This pushed down the unemployment rate from 9.4% to 8.2%. Wages also increased by 4.3% in February. The Nanos confidence index rose from 60.5 to 62.7 in the week of March 12. Housing starts rose by 246K in February, as expected. The BoC’s preferred measures of CPI came in close to the 2% target. Headline CPI was weaker at 1.1% in February. The Canadian dollar rose by 0.3% against the US dollar this week. The correction in oil prices could set the tone for the near-term performance of the loonie, despite robust domestic conditions. However, at the crosses, CAD should have upside. We took profits on our short CAD/NOK position this week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Producer and import prices fell by 1.1% year-on-year in February. February CPI releases also suggest the economy remains in deflation. The Swiss franc fell by 0.4% against the US dollar this week. Safe-haven currencies continue to be sold as yields rise, making the Swiss franc the worst performing currency this year after the yen. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors to stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The trade balance remained in surplus of NOK 25.1bn in February. The Norges bank kept interest rates on hold at 0%. The NOK fell by 1.2% against the dollar this week. The trigger was the selloff in oil prices. However, with the Norges bank signaling a rate hike later this year, placing it ahead of its G10 peers, there is little scope for the NOK to fall durably. Inflation in Norway is above target, and higher mobility later this year will benefit oil-rich Norway. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data releases were a slight miss: Headline CPI came in at 1.4% in February. Core CPI came in at 1.2%. The unemployment rate remained at 8.9% in February. The Swedish krona fell by 0.8% against US dollar this week. Sweden is struggling to contain another wave of the pandemic and this has weighed on the currency this year. The saving grace for the economy has been a global manufacturing cycle that continues humming. Until Sweden is able to get past the pandemic, the currency will continue trading in a stop-and-go pattern. We remain long the SEK on cheap valuations and as a play on the global industrial cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights Even after the COVID-19 pandemic is over, likely within 18 months, many behavioral changes that were forced on society by social distancing will remain. Individuals who have gotten used to working from home, shopping online, and using the internet for socializing and entertainment will continue to do so. Amid any large structural shift, it is easier to spot losers than winners. The biggest losers are likely to be: (1) Parts of the real estate industry, as companies shed expensive city-center office space and office workers move away from big cities; and (2) the travel industry, since business travel will decline. The winners will include: Health care (as governments spend to strengthen medical services); capital-goods producers (with US manufacturers increasingly reshoring production but automating more); and the broadly-defined IT sector which, while expensively valued, is nowhere near its 2000 level and has several years of strong growth ahead.   “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” –  Bill Gates “There are decades where nothing happens, and there are weeks where decades happen.” –  Lenin Introduction The world has been turned upside down since February by the coronavirus pandemic. Households all around the globe have been forced to stay indoors; companies have been forced to drastically change working practices; some industries, such as online shopping or videoconferencing software, have seen a surge in demand. But once the pandemic is over, how many of these changes will stick? What will be the long-term impact on society, the workplace, consumer attitudes, and companies’ strategic planning? How should investors position themselves to take advantage of secular changes in the sectors that will be most affected, ranging from health care and technology, to real estate, retailing, and travel? In this Special Report (which should be read in conjunction with two other recent BCA Research Special Reports on the macro-economic and geopolitical consequences, respectively, of COVID-191), we look at the social and industry implications of the coronavirus pandemic. We assume that, within the next 12-to-18 months, the pandemic will be a thing of the past, either because a vaccine has been developed, or because enough people have caught it for herd immunity to develop. This does not mean that people will be unconcerned about a reoccurrence, or about a new virus triggering another epidemic. Pandemics are not rare, even in modern history (Table 1). And COVID-19 may return as an annual mild seasonal flu (as the 1968 Asian flu did), but which is not serious enough to alter behavior. But the assumption in this report is that, within a couple of years, people will feel comfortable again about being in crowded spaces and traveling, without a need for social distancing or periodic lockdowns. Table 1Estimated Mortality And Infection Rates Of Pandemics During The Past Century But that doesn’t mean that everything will return to the status quo ante. At least some individuals who have gotten used to working from home, video conferencing, and shopping online will continue these practices. Companies will, therefore, need to rethink their employment policies, as well as how they manage their office space, global supply chains, and just-in-time inventories. Government policies towards health care and education will need to be rethought. None of these changes are new. Indeed, the result of an exogenous shock is often simply to accelerate trends that were already in place. E-commerce, telecommuting, and “reshoring” have already been growing steadily for years. COVID-19 is, however, likely to accelerate these shifts. Not every individual or company will change their behavior, but even small changes at the margin can have a significant impact. Ultimately, what these changes amount to is a liberalization of space and time. Employees do not need to be in the same physical space to work together. Students can choose when to listen to a lecture. Music lovers based in a small city can have the same access to a live (streamed) concert as those in London or New York. This Special Report is divided into two sections. In the first section, we examine the meta-changes in consumer and corporate behavior that could result from the pandemic. How widely will the shift from office-based work to “working from home” stick? How much will shopping, entertainment, and education stay online? Will companies really bring back a large chunk of manufacturing from overseas? In the second section, we analyze the impact on specific industries, such as real estate, health care, technology, and retailing, and make some suggestions as to how investors should tilt their portfolios over the longer term to take advantage of these trends. In summary, we identify the winners as health care, technology, and capital-goods producers. The clear losers are in real estate and travel. Retailing and consumer goods will see a significant shakeout, with both winners and losers, but the overall impact on these industries will be neutral. Social Impacts Working From Home Teleworking, or working from home, is hardly new. Craftsmen before the industrial revolution did so as a matter of course. But the development of computers and telecommunications in the 1980s made it feasible for white-collar workers to work from home too. As Peter Drucker wrote as long ago as 1993: "...commuting to office work is obsolete. It is now infinitely easier, cheaper and faster to do what the nineteenth century could not do: move information, and with it office work, to where the people are."2  Until now, however, teleworking has been rare. But the requirements imposed by the pandemic could cause that to change. Technically, it is possible for workers in many job categories to telework effectively. A recent study by Jonathan Dingel and Brent Neiman3 estimated, based on job characteristics, that it is feasible for 37% of all jobs in the US to be done entirely from home (46% if weighted by wages). The vast majority of jobs in sectors such as education, professional services, and company management could be done from home (Table 2). Extending the analysis to other countries, they find that more than 35% of jobs in most developing countries can be done from home, but less than 25% in manufacturing-heavy emerging economies such as Turkey and Mexico (Chart 1). Table 2Share Of Jobs That Can Be Done At Home, By Industry Chart 1Share Of Jobs That Can Be Done At Home, By Country But, in practice, before the coronavirus pandemic, many fewer people than this worked from home. Partly this was simply because many companies did not allow it. A survey by OWL Labs in 2018 found that 44% of companies around the world required employees to work from an office, with no option to work remotely.4 The percentage was even higher, 53%, in both Asia and Latin America. By contrast, OWL did find that 52% of employees globally worked from home at least occasionally, and that as many as 18% of respondents reported working from home always. The pandemic forced many white-collar workers to telework for the first time. The Pew Research Center found that 40% of US adults – and as many as 62% of those with at least a bachelor’s degree – worked from home during the crisis.5  How white-collar workers found the experience, and whether they plan to continue to work from home some of the time even if not required to do so, vary widely. Employers are generally positive about the idea. A survey of hiring managers by Upwork found that 56% believed that remote working functioned better than expected during the crisis (Chart 2). They cited reduced meetings, fewer distractions, increased productivity, and greater autonomy as reasons for this. The major drawbacks were technological issues, reduced team cohesion, and communication difficulties. Another survey, by realtor Redfin, found that 76% of US office workers had worked from home during the crisis (compared to only 36% who worked from home at least some of the time beforehand) and that 33% of respondents who had not worked remotely pre-shutdown expect to work remotely after shutdowns end (with another 39% unsure) (Chart 3). Chart 2Employers Found That Teleworking Worked Well Chart 3Many Employees Expect To Continue Working Remotely After The Pandemic Ends But there are problems too. Research published in the Journal of Applied Psychology found that, while teleworking has some clear advantages, such as improved work-family interface, greater job satisfaction, and enhanced autonomy, it also has drawbacks. Most notably, if workers aren’t in the office at least half the week, relationships with fellow workers suffer, as does collaboration.6 There are also developed countries where backward technology has made the experience of working from home difficult. This is particularly the case in Japan. A survey by the Japan Productivity Center found that 66% of office workers said their productivity fell when working from home; 43% were dissatisfied with the experience. The reasons cited for the dissatisfaction were “lack of access to documents when not in the office” (49%), “a poor telecommunications environment” (44%), and a difficult working environment, such as lack of desk space (44%). Japanese companies remain rather paper-based, and household living space tends to be small. Research carried out on employees at Chinese online travel company Ctrip before the pandemic concluded that home working led to a 13% performance increase but, crucially, there were four requirements for working from home to succeed: Children must be in school or daycare; employees must have a home office that is not a bedroom; complete privacy in that room is essential; and employees must have a choice of whether to work from home.7  After the pandemic, a significant shift in the pattern of office work is likely. Many workers will work remotely part or most of the time. But they will also benefit from coming to an office a certain number of days a month to work together, bond with co-workers, exchange ideas, etc. Online Shopping E-commerce has been growing steadily for years. In the US, it increased by 15% year-on-year in 2019, to reach $602 bn, or 16% of total retail sales (Charts 4 and 5). The share is even higher in some other countries: For example, 25% in China and 22% in the UK. The pandemic caused a big acceleration in e-commerce the first few months of this year, as consumers in most countries around the world were either not allowed to go outside, or felt unsafe doing so. Chart 4The Share Of E-commerce Has Been Steadily Expanding For Years… Data from Mastercard show that, in the worst period of lockdowns in April, e-commerce grew by 63% in the US, and 64% in the UK year-on-year, compared to a decline of 15% and 8%, respectively, in overall retail sales (Chart 6). The growth was particularly apparent in products such as home improvement, footwear, and apparel (Chart 7). Chart 5…With Growth Of Around 15% A Year Chart 6In April, Online Sales Soared…   Chart 7…Especially In Certain Categories Moreover, many consumers in advanced economies bought goods such as clothing, medicine, and books online for the first time, and used services such as online grocery delivery, and apps to order food from restaurants (Chart 8). Note, however, that few consumers bought financial services, magazines, music, and videos online for the first time. Presumably these are products that the vast majority of households had already been consuming online. Chart 8Consumers Shifted Purchases Of Many Items Online It is hard to know how sticky these trends will be. Once shops permanently reopen without restrictions, will consumers simply return to their old habits of going to supermarkets, restaurants, and clothing stores? Perhaps many enjoy the experience of browsing. It seems likely, however, that the newly acquired habit of shopping online will at least accelerate the trend towards e-commerce. Many of those who ordered, for example, supermarket deliveries online for the first time will continue to do so at least occasionally in the future. Other changes are likely too: Many smaller retailers were forced to close their physical stores during the pandemic and so had no choice but to set up an online delivery service. Some struggled with this, but others were aided by companies such as Shopify, which simplify the process of setting up a website, processing payments, and arranging delivery. Shopify now works with over a million merchants. These smaller retailers are now better able to compete with giants such as Amazon. During the lockdown, US consumers notably diversified their online product searches away from Amazon and Google to smaller retailers (Chart 9). Chart 9Search Diversified Away From Amazon And Google We might see a trend towards smaller-scale, local shops benefiting as consumers stick to shopping in smaller stores closer to their homes. Many stores during the pandemic refused to accept cash; this might accelerate the shift towards contactless payments. Consumers may be less focused in future on conspicuous consumption. The trend towards wellness, home-cooking, gardening, crafts, and self-investment might continue. Other Uses Of Technology It is not only work and shopping habits that changed during lockdowns. Individuals also got used to a range of technologies for socializing, entertainment, education, and medical consultation. Consumer surveys by the Pew Research Center show that a third of American adults have socialized online using services such as Zoom, and a quarter have used online systems for work or conferences (Chart 10). But these percentages are much higher for certain demographics. For example, 48% of 18-to-29 year-olds have socialized online, and 30% of this age group have taken online fitness classes. The percentage using video systems for work is as high as 48% for people with a college degree. And, unsurprisingly, with many university courses moving online since the spring, 38% of 18-to-29 year-olds say they have taken an online class. Chart 10Individuals Have Been Socializing And Communicating More Online How sticky these trends will be once the pandemic is over is not easy to forecast. But further research by Pew showed that 27% of US adults believed that online and telephone contacts are “just as good as in-person contact,” and only 8% thought of them as not much help at all, although a rather larger 64% answered that online socializing is “useful but will not be a replacement for in-person contact.” The responses differed little between gender, race, and political views, although fewer people under the age of 30 thought online contacts were as good as in-person ones (Table 3). Table 3How Do Online Interactions Compare To In-Person Ones? Another survey in Japan by Ipsos suggests that people’s values have changed as a result of the pandemic and quarantines, with a greater focus on wellbeing, home-based activities such as cooking, and self-improvement. When questioned, a large percentage of people believe they will persist with these habits even when lockdowns end. For example, 51% of Japanese respondents believe they will continue to enjoy themselves as much as possible at home in their spare time, compared to only 20% who favored entertainment at home before the pandemic (Chart 11).  Chart 11Pandemic Brought A Greater Focus On Wellbeing And Home-Based Activities Other areas that have moved online en masse include education, health care, the judiciary, concerts, and sports (e-sports, and popular sports such as soccer and baseball that are now being played in empty venues). Education at the tertiary level in advanced economies was already partly online before the pandemic. In the US, out of 19.7 million tertiary students in 2017, 2.2 million (13.3%) were enrolled in exclusively online/distance learning courses, and another 3.2 million (19.5%) took at least one course online.8 Of course, everything changed during the pandemic, with 98% of US institutions moving the majority of in-person courses online, and many planning to continue this through the Fall 2020 semester. At the elementary and secondary school level, online education was much more limited pre-pandemic. According to the National Center for Educational Statistics, 21% of US schools offered some courses entirely online in 2016 but, of this 21%, only 6% offered all their courses online and only another 6% the majority of courses. Many of these schools were forced to shift entirely online during lockdowns: According to UNESCO data, at the peak of the pandemic 1.6 billion children (90% of the total in school) in 191 countries attended schools that had closed physically. It seems likely that, while in-person teaching will remain the central method of education, distance and online learning solutions, even at the high school level, will become more prevalent in the future. The health care sector has lagged in technology, in terms of using AI for diagnosis, digitalizing patient records, and offering online doctor-patient consultation. But the use of digital tools had started to increase in recent years, particularly in the number of practices using telemedicine and virtual visits (Chart 12). At the peak of the pandemic in April, the number of telehealth visits in the US rose by 14% year-on-year, compared to a 69% decline in in-person visits to a doctor.9 It seems likely that this trend will continue, as medical practitioners find viritual consultations more efficient and effective for many simple initial diagnoses, and as sick or elderly patients prefer to avoid a physical visit to a surgery.10 Chart 12The Transition To A Digital-Driven Health Care Model Travel Travelers have been very reluctant to get back on airplanes and stay in hotels again, even in countries and regions where the pandemic has eased over the past couple of months (Chart 13). Based on our assumption that the pandemic will be completely over within 18 months, it seems likely that people will eventually resume travelling, at least for leisure and to see family and friends. After previous disruptions to global travel, such as 9/11 and SARS, it took only two-to-three years for air travel to resumed its pre-crisis trend (Chart 14). Chart 13Travelers Remained Reluctant Even When Pandemic Eased Business travel might be very different, however. Salespeople who have become used to making sales calls over Zoom may not feel the need to travel to see clients so much. Conferences, exhibitions, and other events will be increasingly (at least partly) online. Travel budgets are a large expense for many companies. According to estimates by Certify, a travel software provider, spending on business trips in 2019 totalled $1.5 trillion (including $315 billion by US businesses). The availability of a technological alternative to at least some business trips will provide a good excuse for many companies to meaningfully reduce the number of trips and their travel budget. In the future, business travel may become more of a privilege than a necessity. It is easy to imagine a significant decline in overall business travel. Manufacturing Supply Chains Corporate behavior could also change as a result of the disruptions caused by the coronavirus. Companies in the US and Europe realized how vulnerable their complex supply chains are. Popular and political pressure is pushing firms to reshore at least some of their overseas production. Firms will need to build in more “operational resilience,” with higher levels of inventory, less debt, and greater redundancy in their systems. Developed economies such as the US have been deindustrializing for 40 years – since reforms in China in the late 1970s, followed by Mexico and central Europe in the 1990s,  made these countries appealing locations for cheap manufacturing. US manufacturing employment has almost halved since 1980, falling to only 27% of the workforce (Chart 15). Manufacturing output, especially outside of the computer sector, has substantially lagged that of the overall private sector (Chart 16). The US has also fallen behind in automation, with a much lower number of robots per manufacturing worker than in countries such as Germany and Japan (Chart 17). Chart 15US Manufacturing Employment Has Halved Since 1980   Chart 16Manufacturing Output Outside The Computer Sector Has Lagged Chart 17The US Has Relatively Few Robots The pandemic highlighted how vulnerable widely distributed supply chains are. This was clearest in the health care sector. The US is far away the biggest spender on health care research and development (Chart 18). And yet it was unable to provide critical medical equipment such as face masks, testing kits, and ventilators to its population at an adequate rate, mainly because almost 70% of the facilities which manufacture essential medicines are based abroad (Chart 19). During the pandemic, countries such as China and India prioritized their own citizens, forcing the US government to strike emergency deals to avoid drug shortages. Chart 18The US Spends A Lot On R&D In Health Care… Chart 19…But Drug Production Is Mostly Done Overseas Once the crisis subsides, CEOs of American companies (as well as the US government) will have to decide if they are comfortable with the fact that, while they possess a vast store of intellectual capital, the manufacturing of their products happens halfway around the world. What happens if there is another pandemic? What about a global disaster caused by climate change? Finally, and perhaps more worryingly, what happens if tensions between the US and China escalate seriously? This shift will not happen overnight: China still has much cheaper labor, an enormous manufacturing base of factories and parts suppliers, and formidable transportation infrastructure. Many aspects of supply chains are too deep-rooted and the economics too compelling for them to be unwound quickly. Some production will shift from China to other emerging economies. A Biden administration might be less confrontational with China, and could lower some of the Trump tariffs. But, at the margin, companies will choose to build new factories in the US (and in western Europe and Japan), with highly automated systems. Government policy (via both subsidies and tariffs) will encourage these trends. Manufacturers which have lived “on the edge” in recent years, with dispersed supply chains, just-in-time processes, minimal inventories, the fewest possible workers, and the maximum amount of debt compatible with their targeted credit rating (often BBB) now understand the need to build redundancy into their systems. Corporate debt levels are high by historical standards in many countries (Chart 20). Companies may want to build up a buffer of net cash in the future, as Japanese companies did for decades after the bubble there burst in 1990. Inventories have risen a little relative to sales since the Global Financial Crisis but will probably rise further (Chart 21). These trends are likely to be negative for profit margins. Chart 20In The Future, Will Companies Be Happy With This Much Debt... Chart 21...And Such Low Level Of Inventories? Implications For Industries In light of the social changes described above, how will various industries be reshaped over the coming years? Which sectors should investors tilt towards because they are likely to emerge as winners from post-COVID structural shifts? And which are the sectors that investors should avoid since they will suffer from the creative destruction? In the midst of major social and technological change, it is often easier to spot losers than winners. Think of the arrival of the internet in the 1990s. How many investors would have correctly picked Google, Amazon, Apple, and only a handful of others as the winners? It would have been easier to correctly identify industries that were likely to lose out to disruption, such as book retailers, travel agents, newspaper publishers, and TV broadcasters. We start, therefore, with the industries likely to lose out from post-COVID changes. The Losers Real Estate Over the next few years, prime real estate seems the most likely loser. It is not clear how many white-collar workers will choose to work from home in the future, or how many days a month they will want to come into an office to meet with fellow workers. But it seems likely there will be a strong continued trend in the direction of remote working. As a result, demand for prime central-business-district property will fall, given that it is very expensive. In Manhattan, for example, the average workspace for each of the 1.5 million office workers is around 310 square feet. At pre-COVID rental costs, that amounts to an average of $20,000 per employee – and more than $30,000 for A+ grade buildings. And rent is only part of what a company pays: There are also costs for cleaning, utilities, technology, security, coffee machines, and cafeterias on top of that. Employees working at home pay for their own space, utilities, food (and often even computer equipment). The size, location, and layout of offices will need to be rethought. Maybe companies will choose to build a campus in the suburbs, with a range of different working spaces (for meetings, quiet work, or collaboration). They may prefer to rent shared co-working spaces by the day or week. Some real estate developers and builders would be beneficiaries of this. Companies would save money in real estate costs. But they may need to pay a stipend to employees who work at home to cover the extra space they will require, and to upgrade their technology (computer equipment, internet speed, and so on). On the other hand, companies may pay lower salaries for workers who move out of high-cost locations such as Manhattan or London to places where it is cheaper to live. Many office spaces are leased on a long-term basis, so some companies will not be able to move out of big cities immediately. But residential property is more liquid. The trends in work practices might accelerate a shift to the suburbs which has already been emerging over the past few years (Chart 22). Workers will not need to live so close to the company’s office if they will visit it for only a few days a month. Small towns with a lively community and pleasant environment (and decent transportation links to a big city) could grow in popularity. This would be bad news for developers which are specialized in developing residential property in cities such as London, Sydney, Toronto, and Vancouver, and for the owners of those properties. But it might be positive for builders who will develop the new houses and out-of-town office campuses. Chart 22The Shift To The Suburbs Was Already Taking Place This does not mean that cities will wither away. After previous epidemics and crises in history (think the Great Plague of London in the 17th century, or 9/11), they have always bounced back. “Casual collisions” – chance meetings with interesting people which lead to collaborative relationships – are crucial in creative industries, and happen online only with difficulty. Buildings will be repurposed: Retail space will be turned into warehouses or apartments, for example. A fall in rents would allow cities to “degentrify” and attract back young people, making the city more dynamic again. But the period of transition could be painful for some segments of the real estate industry. Travel A permanent decline in business travel would be a significant blow to airlines and hotel chains. Business travelers account for only about 12% of the number of air tickets purchased, but they generate 70%-75% of airlines’ profits. Even discount leisure airlines such as Southwest have in recent years started to target business travelers. And it will not just be airlines that are affected. Data from the US Travel Association show that 26% of the $2.5 trillion in travel-related revenues in the US in 2018 came from business travelers. Of that, 17% goes to air travel, 13% to accommodation, and 5% to car rental. An even larger portion goes to food (21%). Around 40% of hotel rooms are occupied by business travelers. Conference organizers and venues could also suffer: 62% of US business trips are to attend conferences. “Sharing economy” companies would be affected too. In 2018, 700,000 business travelers booked accommodation through AirBnB, and 78% of business travelers use Uber and other ride-sharing services. Furthermore, a slowdown in business travel would have knock-on effects on the leisure travel sector. Surveys suggest that almost 40% of business trips in the US are extended to include leisure activities (“bleisure” in the travel industry parlance). The Winners Health Care A recent report by BCA Research’s Global Asset Allocation service argued in detail that the macro environment for global health care equities will remain very positive in the coming years.11 An aging population in the world, and a growing middle class in emerging countries will steadily raise demand for health care services (Charts 23 and 24). China, in particular, has underinvested in health care: It spends only 5% of GDP, barely higher than it did 20 years ago, and well behind other emerging economies such as Brazil and South Africa (Chart 25). Chart 23Positives For Health Care Include An Aging Population… Chart 24…And A Growing Emerging Market Middle Class As a result of the COVID-19 pandemic, governments everywhere will need to spend more money on health care (or, in the case of the US, perhaps spend it more effectively). In the US, before the pandemic, intensive-care beds were sufficient to cope only with the peak of a normal seasonal influenza breakout. The World Health Organization warns that, while pandemics are rare, highly disruptive regional and local outbreaks of infectious diseases are becoming more common (Chart 26). More money will need to be spent, in particular, on developing health care technology (online consultations, digitalized patient records, track-and-trace systems), on improving senior care homes (80% of COVID-19 deaths in the Canadian province of Quebec were in such facilities), and on biotech (such as gene-related therapies). Chart 25Expenditures On Health Care Will Have To Grow Chart 26Number Of Countries Experiencing Serious Outbreak Of Infectious Disease   The health care equity sector is not expensive, trading in line with its long-run average valuation (Chart 27). Within the sector, biotech and health care technology look more attractive than pharmaceuticals, which are expensive and vulnerable to the price caps proposed by Joe Biden if he is elected US president this November. Chart 27Health Care Stocks Are Not Expensive Technology In a plethora of ways, the pandemic has propelled the use of technology: For working at home, communication, online shopping, entertainment, etc. Companies such as Zoom have moved from niche players to mainstream business providers: Zoom’s peak daily users rose from 10 million in December 2019 to 300 million in April. Chart 28Tech Stocks Are Nowhere Close To Previous Peaks Assuming that at least some of these developments remain in place once the pandemic is over, it is easy to see how technology stocks (broadly defined to include any company that uses information technology as a central part of its business) will continue to prosper. These stocks will not be just in the IT sector, but also in communications and consumer discretionary. Picking the individual winners will be hard: Will Microsoft overtake Amazon in cloud computing? Will Zoom’s much-discussed privacy issues undermine it? Will competitors emerge to Shopify in merchant services? Can Spotify compete with Apple in online music streaming? But the broadly-defined sector seems likely to have improving fundamentals for some years to come. The only question is whether the good news is already priced in, after the huge run-up in stock prices over the past few years. We do not believe it is fully. The valuations of these sectors are still nowhere close to the level they reached at the peak of the TMT Bubble in 1999-2000 (Chart 28), they have strong balance-sheets, and considerable earnings power. For their outperformance to end, it will take one of two things. The first trigger could be a significant shift down in growth. Over the past three years, Amazon has grown EPS at a compound rate of 47%, and Netflix at 76% (Chart 29). Over the next three years (2020-2023), analysts forecast compound EPS growth of 32% for Netflix, 30% for Amazon, 15% for Facebook (compared to 24% in 2016-2019), and 12% for Microsoft (compared to 16%). Those are still impressive growth numbers, and should be achievable as long as these companies can continue to grow market share. Chart 29Can The Big Tech Stocks Keep Growing Earnings At This Rate? The second set of risks would be regulatory: A move to break up companies such as Google and Amazon, the US introducing data privacy legislation similar to that in the European Union, or a move to a digital tax or minimum global taxation. None of these seems likely in the immediate future. Automation/Robotics/Capital Goods The return, at the margin, of some manufacturing to the United States (and other developed economies) will bring about economic changes. Unable to tap into the pool of cheap international labor as easily as before, companies will have to invest significantly in this sector. This will result in the following: A resurgence of manufacturing productivity, thanks to increased investment. An intensification of automation. The US will need to boost the number of robots per capita to compete with Korea, Germany, and Japan. This will further improve productivity. The development of a high-tech manufacturing sector. Analogous to the FAANG stocks during the 2010s, a new group of innovative manufacturing companies could emerge. New infrastructure, roads, factories, and machinery will be needed to replace what is now an outdated capital stock in the US (Chart 30). These trends should all be positive for the capital-goods sector. Such a project would also need large amounts of raw materials. This might push up the prices of commodities such as industrial metals, and benefit materials producers. As mentioned above, it could boost the price of real estate outside of the major cities, where the new manufacturers would be likely to set up. Chart 30The US Capital Stock Is Becoming Outdated Mixed Retailing / Consumer Goods Retailing is likely to see a significant shakeout over the next few years. The cracks have been apparent for some years: Decreasing footfall, and empty units on many high streets and shopping malls, amid the shift to online shopping. A shift to the suburbs and further growth in online shopping will change retailing further. Rents in the highest end Manhattan shopping districts have already fallen noticeably since the start of the year, especially Lower Fifth Avenue (between 42nd and 49th Streets) which is dominated by large chain stores (Chart 31). Shopping malls, particularly undistinguished ones in poorer areas, will continue to suffer. Overall, the US in particular has an excess of retailing space, almost five times as much per capita as the major European economies (Chart 32). Chart 31Manhattan Retail Store Rents Already Falling Sharply Chart 32The US Has Far Too Much Retail Space But it is hard to predict the winners from this shake-out. Overall spending by consumers is unlikely to be significantly affected, so it is a matter of forecasting which companies and formats will emerge victorious. Will Walmart and Target and other large retail chains improve their online offering to fight back against Amazon? Facebook, Shopify, and others have set up new services to compete with Amazon on price – will they be successful? Will small stores start to win back market share? Will supermarkets figure out how to make profits from their order-online-and-deliver services (which are now very costly because most often a human has to run around the store picking out the items ordered), or will new, fully automated competitors emerge? Will new technologies materialize to make it easier to buy clothes online (for example, digitized body measuring systems)? These changes will also affect producers of consumer products. They will have to understand the new channels, and adapt their offerings and positioning strategies accordingly. These changes will make the sector a tricky one. A skilled fund manager might be able to predict which companies’ strategies will be successful. But it could be a problematic area for investors owning individual stocks within the sector who do not have detailed expertise. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "Beyond The Virus," dated May 22, 2020 and Geopolitical Strategy, "Nationalism And Globalization After COVID-19," dated June 26, 2020. 2 Peter E. Drucker, "The Ecological Vision: Reflections on the American Condition," 1993, p.340. 3 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020. 4 OWL Labs, “The State of Remote Work Report,” available at www.owllabs.com. 5 Pew Research Center survey conducted March 19-24 2020. Please see https://www.pewsocialtrends.org/2020/03/30/most-americans-say-coronavirus-outbreak-has-impacted-their-lives/psdt_03-30-20_covid-impact-00-4/ 6 Gajendran, R.S., & Harrison, D.A., “The Good, the Bad, and the Unknown about Telecommuting”,  Journal of Applied Psychology 92(6), 2007. 7 Nicholas Bloom, James Liang, John Roberts & Zhichun Jenny Ying, “Does Working from Home Work? Evidence From a Chinese Experiment,” The Quarterly Journal of Economics (2015), 165-218. 8 Please see educationdata.org. 9 Ateev Mehrotra, Michael Chernew, David Linetsky, Hilary Hatch, and David Cutler, "The Impact of the COVID-19 Pandemic on Outpatient Visits: A Rebound Emerges," The Commonwealth Fund, dated May 19, 2020.  10For more on the long-term outlook for the health care sector, Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight," dated July 24, 2020, available at gaa.bcaresearch.com. 11Please see Global Asset Allocation Special Report, "The Healthcare Revolution: The Case For Staying Overweight,"dated July 24, 2020, available at gaa.bcaresearch.com.

Highlights The Chinese economy continues to recover, albeit less quickly than the first two months following a re-opening of the economy. The demand side of the Chinese economic recovery in May marginally outpaced the supply side, with a notable improvement concentrated in the construction sector. We are initiating two new trades: long material sector stocks versus the broad indices, in both onshore and offshore equity markets. Feature The recovery in China’s economy and asset prices has entered a “tapering phase”, in which the speed of the recovery is normalizing from a rapid rebound two months after the economy re-opened. The direction of the ultra-accommodative monetary and fiscal stance has not changed, but the aggressiveness in the stimulus impulse is abating as the recovery continues. As we highlighted in last week’s report, the announced stimulus at this year's NPC was less than meets the eye of investors.1 Chart 1A Quick Reversal In The Outperformance Of Chinese Stocks Near-term downside risks in Chinese stocks were highlighted by last week’s quick reversal in the outperformance of Chinese equities relative to global benchmarks (Chart 1). As the US and European economies re-open and the stimulus impulse in major developed markets (DMs) is at peak intensity, Chinese stocks will underperform those in DMs, particularly US stocks. The re-escalation in Sino-US tensions will also add to the near-term volatility in Chinese equities. Therefore, we maintain our tactical (0-3 months) neutral view on aggregate Chinese equity indexes, in both domestic and offshore markets. Beyond Q2, however, our baseline view still supports an outperformance in Chinese stocks. The stepped-up stimulus measures since March should start to trickle down into the broader economy. Global business activities and demand will slowly normalize in the summer, helping to revive China’s exports. Moreover, an intensified pressure on employment, indicated in this month’s employment subcomponents in manufacturing and non-manufacturing PMIs, should prompt policymakers to roll out more growth-supporting measures in Q3. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 2ASpeed Of Manufacturing Activity Recovery Has Moderated China’s official manufacturing PMI slipped to 50.6 in May from 50.8 a month earlier (Chart 2A). While the reading suggests that manufacturing activities are still in an expansionary mode, the speed of the expansion has moderated compared with April and March. The supply side of manufacturing activities and employment were the biggest drags on May’s official PMI. The production subcomponent in the PMI decelerated whereas new orders increased from April (Chart 2A, bottom panel). The net result is an improved supply-demand balance in the manufacturing sector, however, the improvement is marginal. It also differs from the V-shaped recovery in 2008/09, when both new orders and production subcomponents grew simultaneously (Chart 2B). The demand side of the economy is still concentrated in the policy-driven construction sector. The rebound in construction PMI continues to significantly outpace that in manufacturing and non-manufacturing PMIs (Chart 2C, top panel). The construction employment sub-index ticked up by 1.7 percentage points in May, compared with a slowdown of 0.8 percentage points in manufacturing and 0.1 percentage points in non-manufacturing employment PMIs (Chart 2C, bottom panel). Chart 2BDemand Struggles To Outpace Supply Chart 2CDemand Recovery Is Concentrated In Construction While a buoyant construction sector should provide a strong tailwind to raw material prices and related machinery sales, a laggard recovery from other sectors means the upside potential in aggregate producer prices (PPI) will be limited in the current quarter. In May, there was a rebound in the PMI sub-indices measuring raw material purchase prices and ex-factory prices, which heralds easing in the contraction of PPI in Q2 (Chart 3). However, neither of the PMI price sub-indices has returned to levels reached in January, when PPI growth was last positive. Moreover, weaker readings in the purchases and raw material inventory subcomponents suggest that manufacturers may be reluctant to restock due to sluggish global trade and a lagging rebound in domestic demand (Chart 3, bottom panel).  This month’s PMI shows that the employment subcomponents in both the manufacturing and non-manufacturing PMIs are contracting (Chart 4). Because demand for Chinese export goods remains sluggish, we expect unemployment in China’s labor-intensive export manufacturing sector to rise in Q2 and even into Q3. The intensified pressure on employment will likely prompt Chinese policymakers to roll out more demand-supporting measures. Chart 3PPI Contraction Will Ease But Upside Limited In Q2/Q3 Chart 4Employment In Trouble, A Catalyst For More Easing The BCA Li Keqiang Leading Indicator rose moderately in April. A plunge in the Monetary Conditions Index (MCI) limited the magnitude of the indicator's increase, offsetting an uptick in money supply and credit growth (Chart 5). A rapid disinflation in headline consumer prices (CPI) since the beginning of this year has pushed up the real savings deposit rate, which contributed to the MCI’s nose-dive. In our view, the MCI’s sharp drop is idiosyncratic and does not signify a tightening in the PBoC’s monetary stance or overall monetary conditions. Huge fluctuations in food prices have been driving the headline CPI since March 2019, while the core CPI remains stable. While food prices historically have very little correlation with the PBoC's monetary policy actions, a disinflationary environment will provide the central bank more room for easing. Odds are high that the PBoC will cut the savings deposit rate for the first time since 2015.  Chart 5Monetary Conditions Are Not As Tight As The Indicator Suggests The yield curve in Chinese government bonds quickly flattened around the time of the National People’s Congress (NPC), with the short end of the curve rising faster than the long end (Chart 6). This is in keeping with our assessment that while the market is expecting the recovery to continue in China, it is unimpressed with the intensity of upcoming stimulus and monetary easing. Monetary easing seems to be taking a pause, but we do not think this indicates a change in the PBoC’s policy stance (Chart 7). Instead, weak global demand, slow recovery in the domestic economy and intensified pressure on domestic employment, all will incentivize policymakers to up their game by mid-year. As such, we expect the yield curve to steepen again in H2, with the short-end of the curve fluctuating at a low level and the 10-year government bond yield picking up when the economy gains traction. Chart 6The Bond Market May Be Incorrectly Pricing In A Monetary Tightening Chart 7A Pause Before More Easing In June The spread in Chinese corporate bond yields has dropped by more than 30bps from its peak in April. This is in line with that of major DM countries and a reflection of the easier liquidity conditions globally (Chart 8). We anticipate that the yield spreads in Chinese corporate bonds will continue to normalize. However, a flare in US-China tensions will put upward pressure on the financing costs of lower-rated corporations (Chart 8, bottom panel). The default rate among Chinese corporate bonds is unlikely to rise meaningfully this year, in light of ultra-accommodative monetary conditions and the Chinese government’s bailout programs to backstop corporate defaults. Chinese corporate bond defaults and non-performing loans historically have correlated with periods of financial sector de-leveraging and de-risking, other than during economic downturns. We continue to recommend investors hold China’s corporate bonds in the coming 6-12 months in a USD-CNH hedged term. Chart 8Financing Costs May Rise For Lower-Rated Corporations Chart 9Cyclicals Are Struggling To Break Out Among Chinese equities, cyclical sectors have struggled to outperform defensives in both onshore and offshore markets (Chart 9). This reflects investors’ concerns over the slow recovery in domestic demand and heightened geopolitical risk between the US and China. As such, we continue to favor domestic, demand-driven sectors among the cyclical stocks, such as consumer discretionary and construction-related materials. We upgraded consumer discretionary stocks from neutral to overweight on May 20, and we are now initiating two trades to long material sector stocks versus the broad markets in both the domestic and investable markets. The constituents of both China’s investable and domestic material sectors are highly concentrated in the metal and mining subsectors, which roughly account for half of the material sectors’ weight in the MSCI and MSCI A Onshore Indexes, respectively. Chart 10 highlights that the material sectors’ relative performance is highly correlated with CRB raw materials in both domestic and investable markets. Given that China’s credit cycles historically lead the CRB material index by about six months, China’s massive credit stimulus will boost CRB raw materials by end-Q2 and thus, the outperformance of the material sectors.  The RMB has depreciated by almost 3% in the wake of a re-escalation in US-China frictions. The CNY/USD spot rate is approaching its weakest point reached in September 2019 (Chart 11). Furthermore, on May 29, the PBoC set the CNY/USD reference rate at its lowest level since 2008, a move that suggests defending the RMB is no longer in China’s interest. Downward pressure on the RMB will persist in the months leading up to the November US presidential election. The US economy is in a much more fragile state than in 2018/19, which may hinder President Trump’s willingness to resort to tariffs between now and November. However, we cannot completely roll out the probability that Trump will impose further tariffs on Chinese exports, if he is losing the election through weak public support and is removed from his financial and economic constraints.  In any case, in the coming months CNY/USD exchange rate will likely continue to decouple from the economic fundamentals such as interest rate differentials (Chart 11, bottom panel). Instead, the exchange rate will be largely driven by market sentiment surrounding the US-China frictions.  Volatility in CNY/USD will increase, but the overall trend in the CNY/USD will continue downwards as long as the escalation in US-China tensions persists. On a 6- to 12-month horizon, however, we expect that the depreciation trend in the RMB to moderately reverse as the Chinese economy continues to strengthen. Chart 10Material Sectors Should Benefit From The Stimulus And Construction Boom Chart 11The CNY/USD Will Continue To Decouple From Interest Rate Differentials Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," dated May 28, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations