Monetary

Highlights US Vs. Europe: Growth and inflation momentum remains stronger in the US versus Europe. The latter is taking the bigger economic hit from more severe Omicron economic restrictions and a greater exposure to slowing Chinese demand. European inflation has accelerated, but remains slower and less broad-based than elevated US inflation. The backdrop remains more negative for US fixed income compared to Europe. UST-Bund Spread: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures). Feature Chart of the WeekUS Bond Yields & Bond Volatility Are Both Rising Global fixed income markets are off to a volatile start in 2022, on the back of significant repricing of US interest rate expectations. The 10-year US Treasury yield now sits at 1.85%, up +34bps so far in January and is up +72bps from the August 4/2021 intraday low of 1.13%. The 2-year US yield, which is even more sensitive to changes in Fed expectations, is 1.04%, up +31bps so far this month and up +87bps since early August 2021. Yields are rising in other countries as well, with the 10-year benchmark government bond yield up year-to-date in the UK (+24bps), Canada (+45bps) and even Germany (+18bps) where the Bund yield is threatening to return to positive territory. US Treasuries are selling off as markets have heeded the hawkish shift in the Fed’s interest rate guidance. The US overnight index swap (OIS) curve now discounting 89bps of Fed rate hikes in 2022. Bond volatility further out the Treasury curve has increased as yields have moved higher, with the realized volatility of the Bloomberg 7-10 US Treasury index now at an 19-month high (Chart of the Week). We continue to recommend a defensive strategic posture towards direct US Treasuries with below-benchmark exposure on both duration and country allocations in global bond portfolios. However, we prefer a more efficient way to position for the same theme of rising US yields – betting on a wider 10-year US Treasury-German Bund spread. US Growth & Inflation Fundamentals Support A More Hawkish Fed The rise in global bond yields seen in recent weeks has inflicted damage on risk assets, but not in a consistent fashion. Equity markets have taken the brunt of the hit, with the S&P 500 down around -3% so far in January with the tech-heavy NASDAQ down -6%. Yet the MSCI emerging market equity index is up around +1%, European equities are flat and global high-yield corporate bond spreads are essentially unchanged so far this month. While higher bond yields are reflecting expectations of more global monetary tightening over the next year, medium-term interest rate expectations remain subdued. Our proxy for the market pricing of terminal interest rate expectations – 5-year OIS rates, 5-years forward – remains at or below pre-pandemic levels in the US, the UK, Canada and the euro area (Chart 2). Risk assets are performing relatively well in the face of higher bond yields because markets still do not believe that a major increase in interest rates will be needed in the current global tightening cycle. We see this – the likelihood that interest rates will have to rise much more than markets expect - as the biggest vulnerability for global bond markets over the next couple of years. The US remains the “poster child” for this view. In the US, core CPI inflation accelerated to an 31-year high of 5.5% in December. The pickup in US inflation continues to be broad-based, with the Cleveland Fed median CPI and trimmed mean CPI inflation measures reaching 3.8% and 4.8%, respectively (Chart 3). This massive run-up in US inflation has filtered through to medium-term household inflation expectations; the preliminary University of Michigan consumer survey for January showed that inflation 5-10 years out is expected to be 3.1% - the highest level in 13 years. Chart 2Rising Yields Are Not A Threat To Risk Assets ... Yet​​​​​ Chart 3The Fed Cannot Ignore Elevated Inflation Expectations​​​​​​ Chart 4US Demand Steadily Normalizing From The Pandemic Shock While much of the run-up in US inflation over the past year has been fueled by supply chain disruption and high energy prices, there is still a robust demand component to the high inflation. Consumer spending on goods remains elevated versus its pre-pandemic trend, while services spending is steadily returning back to the pre-pandemic pace (Chart 4). The overall US unemployment rate is now down to 3.9%, the lowest level since February 2020, with broad-based strength in the US labor market across most industries (bottom panel). The rise in consumer inflation expectations has to be most worrisome to Fed officials. Yes, market-based inflation expectations have already seen a significant run-up since the mid-2020 lows, and have even drifted down a bit of late on the back of the more hawkish rhetoric from the Fed. However, survey-based measures of inflation expectations tend to be less volatile than market-based measures, and typically follow trends in realized inflation, which is not slowing down in the US. In other words, rising household inflation expectations are a more reliable indication that an inflationary mindset is becoming entrenched in consumer behavior. US inflation dynamics are transitioning away from supply-driven goods inflation toward more lasting domestically driven forces like tight labor markets, faster wage growth and rising housing costs (Chart 5). Measures of supply chain disruption like global shipping costs are showing signs of peaking (top panel), while commodity price momentum has clearly rolled over – both should eventually feed into slower goods inflation this year. At the same time, tight labor markets will continue to boost US employment costs, which historically have been strongly correlated to US services inflation (middle panel). Chart 5US Inflation Pressures Remain Intense Meanwhile, shelter costs, which represents 32% of the US CPI index, were up 4.2% on a year-over-year basis in December and are likely to continue accelerating given a dearth of housing supply versus demand that is pushing up both house prices and rents (bottom panel). Tying it all together, there are good reasons why the Fed has ramped up the hawkish rhetoric over the past couple of months. However, with the US OIS curve now discounting between 3-4 rate hikes in 2022, it will be harder to generate a second consecutive year of negative returns in the US Treasury market this year. Dating back to the early 1970s, there have only been five calendar years where the Bloomberg US Treasury index delivered an outright negative total return: 1994, 1999, 2009, 2013 and 2021 (Chart 6). None of the four cases prior to last year saw negative returns in the following year, as Treasury yields fell in 1995, 2000, 2010, 2014. Yet even the episodes that saw consecutive years of US yield increases – 1974-75, 1977-81, 1987-88, 2005-06 and 2015-16 – did not see outright negative returns from the Bloomberg US Treasury index. Chart 6Negative Return Years For US Treasuries Are Rare Given the starting point of deeply negative real US bond yields, and interest rate expectations that remain too low beyond 2022, we still see value in staying below-benchmark on US duration exposure on a medium-term basis. However, we see a more efficient way to play for higher Treasury yields this year by positioning US Treasury underweights/shorts versus overweights/longs in government bonds in a region where discounted rate hikes will not happen – Europe. The ECB Is In No Hurry To Hike Rates The same supply driven factors that have pushed up US inflation over the past year have also lifted inflation in the euro area. Headline HICP inflation reached an 30-year high of 5.0% in December, while core HICP inflation hit an all-time high of 2.6%. The European Central Bank (ECB), however, is unlikely to deliver any rate hikes in 2022 even with the high inflation, for several reasons (Chart 7): Growth momentum entering 2022 was soft, thanks to Omicron related economic restrictions at the end of 2021 and also weak demand for European exports from China. It will take time for both of those factors to reverse, thus reducing any growth related pressure to tighten monetary policy. Inflation expectations are not exceeding the ECB 2% inflation target, with the 5-year/5-year forward EUR CPI swap now at 1.9% even with headline inflation of 5.0%. The surge in European energy prices will eventually subside in the first half of 2022, which will reduce inflationary pressure on the ECB to tighten. The ECB is ending its pandemic emergency bond buying program (PEPP) in March, and is only partially replacing that buying activity by upsizing its existing pre-pandemic asset purchase program (APP). The ECB will not want to compound the effect of this “tapering” of bond buying by also hiking interest rates, which would surely tighten financial conditions further through higher Italian government bond yields, rising corporate bond yields and a firmer euro. There is little evidence to date showing any pass-through of higher energy-fueled inflation into more domestically-driven inflation. Euro area wage growth was only 1.3% as of the latest available data in Q3/2021 (which is still well after realized inflation had started to accelerate), highlighting the lack of visible “second round” effects on euro area inflation from high energy prices that would prompt the ECB to consider rate hikes (Chart 8). Chart 7An ECB Rate Hike In 2022 Is Unlikely​​​​​​ Chart 8Limited 'Second Round' Effects From Energy-Driven European Inflation​​​​​​ The EUR OIS curve is discounting 7bps of rate hikes by year-end. Even that modest amount will not be delivered, which will limit how much further European government bond yields will rise this year. A Better Mousetrap: Playing UST Bearishness Through UST-Bund Spread Widening Trades Combining our view of an increasingly hawkish Fed and a still-dovish ECB produces our highest conviction investment recommendation for 2022: positioning for a wider 10-year US Treasury/Germany Bund spread. This can be done by underweighting the US versus core Europe in global bond portfolios, or shorting US Treasury futures versus German Bund futures as we are already recommending in our Tactical Trade Overlay (see page 15). A Treasury-Bund spread widening view is a more efficient way to play for a more hawkish Fed and higher US Treasury yields, for several reasons: There are many examples over past 30 years where the Treasury-Bund spread widened in consecutive years (Chart 9). This is in contrast to the fewer occurrences of consecutive years of rising Treasury yields shown earlier in this report. Thus, there are better odds that last year’s Treasury-Bund spread widening can be repeated in 2022. Chart 9Consecutive Years Of A Rising UST-Bund Spread Happen Often The realized volatility of Treasury-Bund spread trades is almost always lower than that of an outright short position in US Treasuries, but the direction of returns of the two trades is similar (Chart 10). This shows that there is directionality in the Treasury-Bund spread (i.e. it is driven far more by the movements of US yields), but that is a welcome feature given our more bearish view on US Treasuries. The Treasury-Bund spread remains well below fair value on our fundamental valuation model, with fair value increasing due to widening US-European inflation differentials (Chart 11). Tighter relative monetary policies this year (more tapering and rate hikes from the Fed compared to the ECB) also favor a wider fair value spread on our model. Chart 10UST-Bund Wideners Have Lower Volatility Than Outright UST Shorts​​​​​ Chart 11The UST-Bund Spread Looks Very Cheap On Our Model​​​​​​ The gap between our 24-month discounters, which measure the change in policy interest rates over the next two years discounted in OIS curves, for the US and euro area is a reliable leading indicator of the 10-year Treasury-Bund spread (Chart 12, bottom panel). The “discounter spread” is currently calling for the Treasury-Bund spread to widen by more than the current path discounted in US Treasury and German Bund forward rates. Chart 12Position For More UST-Bund Spread Widening In 2022​​​​​​ Chart 13UST-Bund Spread Is Not Technically Stretched​​​​​ The Treasury-Bund spread is not stretched from a technical perspective (Chart 13). The spread is sitting right at its 200-day moving average and the 26-week change in the spread (a measure of price momentum) is rising but remains well below previous peak levels that have capped past spread increases. Summing it all up, the case is strong for including US-Germany spread widening positions as core holdings in investor portfolios in 2022. The current spread is 185bps and we have a year-end target of 225bps. Bottom Line: With markets already priced for multiple Fed rate hikes in 2022, it is now harder to earn significant returns shorting US Treasuries outright compared to 2021. We prefer positioning for higher US bond yields through less-volatile US Treasury-German Bund spread widening positions, with the ECB unlikely to deliver even the single discounted 2022 rate hike. We recommend the position both as a structural allocation in bond portfolios (underweight the US versus Germany) and as a tactical trade (selling US Treasury futures versus Bund futures).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Duration: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. Interest Rate Policy: The Fed will deliver its first rate hike in March and will lift rates 2 or 3 more times this year. We see the fed funds rate moving above 2% this cycle, higher than what is currently priced in the market. Fed Balance Sheet: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. Feature Chart 1Market Expectations Are Too Low Rate hikes are just around the corner. In fact, there is a growing consensus among FOMC participants that it will be appropriate to deliver the first rate hike in March, as soon as net asset purchases reach zero. Just last week, San Francisco Fed President Mary Daly called a March rate hike “quite reasonable” and Fed Vice-Chair Lael Brainard testified that the Fed will be “in a position” to lift rates as soon as purchases end. Brainard also mentioned that the Fed has discussed shrinking its balance sheet.1 We expect the Fed to follow through with a 25 basis point rate hike in March, and with 2 or 3 more hikes over the course of 2022. We also see the Fed shrinking its balance sheet this year, via the passive runoff of maturing securities. With all that in mind, this week’s report draws on the experience of past rate hike cycles to give us a sense of what Treasury returns to expect as the Fed lifts rates. We also discuss how the Fed’s balance sheet will evolve over the next few years.  Treasury Returns During Rate Hike Cycles Table 1 provides a useful summary of Treasury returns during the prior four rate hike cycles. The table shows excess Treasury returns versus cash for the Bloomberg Barclays Treasury Index as well as its Intermediate Maturity and Long Maturity sub-indexes. Table 1Treasury Returns During Fed Rate Hike Cycles The first conclusion we draw is that Treasury returns are generally poor during Fed tightening cycles. Intermediate maturity Treasuries underperformed cash in all four cycles. Long maturity Treasuries provided only modestly positive returns in two of the four cycles and deeply negative returns in one of them. One important caveat is that our analysis only considers cycles where the Fed lifted rates multiple times in a row. For example, we exclude the 1997-98 period when one rate hike in 1997 was quickly reversed in 1998. We also define the most recent tightening cycle as spanning from 2015 to 2018 even though the Fed kept the policy rate steady from December 2015 to December 2016. Obviously, if the Fed is forced to abandon its tightening cycle after one or two hikes, then Treasury returns will be much stronger than our historical analysis suggests. Next, let’s dig a bit deeper by looking at each rate hike cycle individually. The 2015-2018 Cycle Chart 22015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target fed funds rate by 225 bps, from a range of 0% - 0.25% to a range of 2.25% - 2.5% (Chart 2). If we look at the 36-month discounter on the day before the first hike (Chart 2, panel 3), it shows that the market was priced for 159 bps of tightening over the next three years. The fact that the Fed delivered more tightening (225 bps) explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield is another useful metric because it is a good approximation of the market’s expected terminal fed funds rate, i.e. the fed funds rate at the end of the tightening cycle. The 5-year/5-year forward Treasury yield stood at 2.92% in December 2015, slightly above where the fed funds rate peaked in 2018 (Chart 2, bottom panel). This explains why long-maturity excess Treasury returns were slightly positive during the cycle.         The 2004-2006 Cycle Chart 32004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span (Chart 3). The 24-month fed funds discounter stood at 369 bps the day before the first hike (Chart 3, panel 3), indicating that the market discounted 31 bps less tightening than was ultimately delivered. Once again, this explains why excess Treasury returns were negative for short and intermediate maturities. The 5-year/5-year forward Treasury yield was 5.72% just prior to the first hike in June 2004 (Chart 3, bottom panel). But, as was the case in the 2015-2018 cycle, the fed funds rate never reached this level. It peaked at 5.25% in 2006 and long-maturity excess Treasury yields were somewhat positive as a result.                 The 1999-2000 Cycle Chart 41999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5% (Chart 4). The 12-month fed funds discounter stood at 108 bps on the day before the first hike (Chart 4, panel 3). Once again, this was slightly less than the 175 bps of tightening that transpired. Excess returns for short and intermediate maturity Treasuries were negative as a result. The 5-year/5-year forward Treasury yield was 5.99% on the day before the first hike (Chart 4, bottom panel). This time, the market’s assessment proved to be too low compared to the funds rate’s 6.5% peak. This divergence explains why long-maturity Treasury excess returns were worse during this period than they were in the 2015-18 and 2004-06 cycles.                 The 1994-1995 Cycle Chart 51994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995 (Chart 5). The 12-month discounter was only 130 bps at the beginning of the tightening cycle, well short of the 300 bps rate increase that was delivered (Chart 5, panel 3). This large divergence explains why excess Treasury returns were so poor during this period. Interestingly, the 5-year/5-year forward Treasury yield stood at 6.69% just prior to the first hike (Chart 5, bottom panel), not that far from the ultimate peak in the fed funds rate. In other words, while market expectations for the near-term path of interest rates were too low, expectations for the ultimate peak in interest rates were fairly accurate. However, terminal rate expectations became unmoored when the Fed started to tighten, and the 5-year/5-year forward Treasury yield rose all the way to 8.5%, far above the fed funds rate’s ultimate peak. This dramatic shift in terminal rate expectations explains the deeply negative long-maturity Treasury returns observed during the period. Of course, those losses were quickly reversed in H1 1995 once it became clear that the Fed would not lift rates further. The 5-year/5-year forward Treasury yield plummeted back to 6.5%. Investment Implications Let’s apply the above analysis to today’s situation. At present, the 12-month fed funds discounter stands at 93 bps. The 24-month discounter is 151 bps and the 36-month discounter is 159 bps (Chart 1). In other words, the market is discounting that the Fed will deliver between 3 and 4 rate hikes this year, but only 2 more in 2023 before the funds rate stabilizes at roughly 1.5%. Our expectation is that the fed funds rate will rise to at least 2% during the next three years, and we therefore continue to recommend running below-benchmark portfolio duration. For its part, the 5-year/5-year forward Treasury yield is currently 2.03%. This is at the low-end of survey estimates for the long-run neutral fed funds rate (Chart 1, bottom panel). We expect the 5-year/5-year forward Treasury yield to rise closer to the middle of the range of survey estimates (~2.25%) as it becomes clear that the fed funds rate will rise to at least 2%. It’s also possible that, like in the 1994-95 episode, terminal rate expectations will rise dramatically as the Fed lifts rates more quickly than anticipated. This, however, is not our base case outlook given that expectations for a low terminal fed funds rate are very well entrenched. Bottom Line: A look at past rate hike cycles shows that Treasury returns are generally low, though not always negative. For the current cycle, we continue to recommend a below-benchmark portfolio duration stance as we don’t think the full extent of Fed rate hikes is adequately priced in the yield curve. The Balance Sheet Outlook Chart 6Hike First, Then QT We expect the Fed to start shrinking its securities holdings this year. The process will probably begin in the first half of the year after one or two rate hikes have been delivered. To arrive at this conclusion, we first look at how the Fed proceeded during the last tightening cycle. Back then, the Fed waited until the funds rate was around 1% before it started to shrink its balance sheet in September 2017 (Chart 6). Notably, the Fed didn’t immediately move toward the full passive runoff of its portfolio. Rather, it started slowly by permitting only $6 billion of Treasuries and $4 billion of MBS to mature in October 2017. These amounts were gradually increased in the subsequent months. The Fed will move more quickly toward balance sheet reduction this cycle and the pace of said reduction will be faster. Here are the relevant passages from the minutes of the December FOMC meeting: Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. […] Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. Many participants also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable…2 From these quotes, we surmise that balance sheet runoff will start earlier than last time – after one or two rate hikes instead of four. Also, while the runoff will proceed more quickly than last time, there is still support for maintaining monthly caps on the pace. The Fed will probably not move immediately to the complete passive runoff of its portfolio, and outright bond sales do not appear to be part of the discussion. One concern that investors might have about the Fed’s balance sheet runoff is the extra supply of Treasuries that will hit the market. As an upper-bound, if we assume complete passive runoff starting in April 2022, the Fed’s Treasury holdings will shrink from $5.7 trillion today to $3.5 trillion by the end of 2024, adding an average of $715 billion extra Treasury supply to the market each year (Chart 7). If we exclude T-bills and TIPS to focus only on coupon-paying nominal Treasury securities, then we calculate that Fed holdings will fall from $4.9 trillion to $3 trillion, adding an extra $639 billion of supply to the market on average for the next three years. However, it’s important to note that Fed policy alone doesn’t dictate the supply of Treasury securities. The Treasury department’s issuance plans also need to be considered. When the Fed allows a maturing bond to passively roll off its portfolio it doesn’t dump that bond directly into the market. Rather, the Treasury Department issues new debt to replace the maturing bond. The Treasury could decide, for example, to increase T-bill issuance instead of coupon issuance. In fact, this sort of decision becomes more likely if Treasury officials are concerned about dumping too much coupon supply on the market. Currently, the Treasury Department targets a range of 15% - 20% for the amount of outstanding T-bills as a proportion of the overall funding mix, a target that it is hitting (Chart 8). However, the minutes from the most recent Quarterly Refunding meeting stressed that the Treasury feels the need to maintain “flexibility” when it comes to this target range and noted that “there is likely more leeway at the top of the recommended range than at the bottom.”3 Chart 7The Pace Of ##br##Runoff Chart 8T-bill Issuance Could Rise As The Fed's Portfolio Shrinks Finally, it is important to consider the extent to which the Fed will be able to shrink its balance sheet. The Fed’s goal will be to achieve a reserve supply that allows it to maintain the funds rate within its target band without putting undue pressure on either its Overnight Reverse Repo Facility (ON RRP) or its new Standing Repo Facility (SRF). Chart 9The Fed's Balance Sheet Was Too Small In September 2019 The ON RRP acts as a floor on interest rates and its usage therefore increases when the Fed’s balance sheet is too large. The third panel of Chart 9 shows that this is currently the case. Conversely, the SRF acts as a ceiling on interest rates and its usage will ramp up if the Fed’s balance sheet becomes too small. This last occurred in September 2019 when the Fed briefly lost control of interest rates and was forced to increase repo holdings and reserve supply (Chart 9).​​​​​​​ Going forward, the Fed will continue to run down its balance sheet until ON RRP usage drops close to zero. However, it will want to stop reducing its holdings before SRF usage picks up. It is highly uncertain when this will occur, but we suspect that the Fed won’t be able to get the balance sheet back to September 2019 levels before seeing SRF usage increase. Bottom Line: The Fed will start the passive runoff of its securities holdings in the first half of this year, after one or two rate hikes have been delivered. Balance sheet reduction will proceed more quickly than it did last cycle, but the Fed will refrain from outright sales. While the size of the Fed’s balance sheet will shrink during the next few years, it will remain larger than it was in September 2019.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see https://www.reuters.com/business/exclusive-feds-daly-march-liftoff-is-quite-reasonable-2022-01-13/ and https://www.nbcnews.com/business/economy/interest-rate-hike-come-soon-march-feds-brainard-signals-rcna12112 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20211215.pdf 3 https://home.treasury.gov/news/press-releases/jy0464 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights It’s true that rising rates often precipitate bear markets, but it takes a while, … : We subscribe to the view that expansions are more likely to be murdered by the Fed than die of old age. It’s hard to envision a plausible scenario in which the Fed could hike rates enough in 2022 to kill this one, though, and even the first half of 2023 would be a reach.  … because the Fed only seeks to slow the economy when it’s firing on all cylinders: Earnings are typically growing at a rapid clip and risk aversion is a distant memory when the Fed begins the process of draining the punch bowl. The fed funds rate tipping point can only be definitively identified after the fact, but our estimate has an impressive track record: No one knows for sure where the line of demarcation between easy and tight monetary policy lies, but equities have shined when the fed funds rate is below our equilibrium estimate. We do not share the view that Tech stocks are especially vulnerable to higher interest rates: Although it lacks empirical support outside of a small subset of observations, the Tech vulnerability view has spread more widely than the Omicron variant. Feature Last week’s report discussing the equity impact of impending rate hikes elicited a lot of reaction. A discussion with one investor usually has relevance for other investors, so we are sharing a composite of the questions we received, along with our responses. It gives us the chance to elaborate on some points that we did not previously address in full, but our conclusion remains unchanged. History argues that equities have little to fear from an incremental rate hike campaign, and we expect that they will generate sizable positive excess returns above Treasuries and cash over the next twelve months. The Fed, With Rate Hikes, In The Board Room Why shouldn’t investors be concerned about rate hikes when you yourself have said that the Fed precipitates recessions? As the last expansion stretched on for a record length of time, we regularly repeated the line that expansions don’t die of old age, they die because the Fed murders them. It fits well with our tipping point view of rate hikes and we wholly subscribe to it. It is important to bear in mind, however, that the Fed’s tools act much more slowly than the lethal array of objects in the game of Clue. As we highlighted last week, monetary policy acts with long and variable lags and the Fed accordingly tightens it in increments allowing for real-time feedback that might help it tailor its actions to evolving economic conditions. Ex-the pandemic, tight monetary policy has been a necessary, albeit not sufficient, recession condition for the 60 years covered by our equilibrium fed funds rate estimate. Although not every instance when the fed funds rate exceeded its equilibrium level preceded a recession, no recession occurred when the funds rate was below equilibrium (Chart 1). Owing to monetary policy’s lagged effects, however, the recessions didn’t begin until well after the Fed began to tighten policy. On average, each recession arrived 26 months after Phase I kicked off and 12 months after the policy cycle entered Phase II (Table 1). Peak growth occurs in the early stages of rate hikes, while the Fed is merely easing up on the gas; deceleration only ensues in the latter stages, when the Fed pushes down on the brake pedal. Chart 1Rate Hikes Are A Necessary, But Not Sufficient, Recession Condition ... Table 1... And It Takes A While For The Economy To Feel Their Full Effect Index P/E Multiples Don’t Collapse Overnight It’s often said that the Fed hikes rates until something breaks. If equities are ultimately going to break in the process, why wouldn’t a prudent investor read the first rate hike, or even the run-up to it, as a sign to begin reducing exposure? We showed last week that signal measures of economic activity – hiring, lending, spending and GDP – grow well above their through-the-cycle pace while the Fed is tightening policy. Corporate earnings do, too, and S&P 500 earnings expectations have risen most rapidly when the Fed is hiking rates, with Phase I growth nearly doubling aggregate growth (Chart 2, middle panel). Earnings gains are vulnerable to dilution from multiple de-rating, but Phase I multiples have been roughly flat in the aggregate (Chart 2, bottom panel). Perhaps investors recognize that equities don’t break until well after the Fed starts hiking rates, or double-digit earnings growth makes them lose sight of the likelihood that they eventually will. Chart 2Our Definitions Of The Phases Must Be Close To The Mark Based on the empirical record, investors judged by their relative performance should not reduce equity exposure until the rate hiking campaign is well advanced. Phase I has produced the best returns of any phase in the 42 years that earnings expectations have been compiled and missing out on them could be harmful to a professional investor’s career (Chart 2, top panel). Today’s Starting Point Is Unusually Demanding Have equities ever been this expensive at the start of a tightening cycle? History suggests that equities can rally in a “normal” Phase I even after some initial turbulence, but how much scope do they have to rise from current valuation levels? There is unfortunately scarcely any empirical data to address this question. The nine Phase I episodes account for just eight years of the 42-year earnings expectations era and several of them are very short (Table 2). The one instance when forward multiples were at or above today’s levels, from June through October of 1999, they were able to hold their ground, falling less than a half of a multiple point, or 1.5%. Earnings expectations grew by 6.3% over that period, allowing the S&P 500 to advance at the rate of about 1% per month, in line with its overall Phase I performance since 1979. Table 2Multiples Have Held Their Ground In Phase I Empirically, however, robust growth in earnings expectations is the basis for overweighting stocks in Phase I, not multiple expansion. We do not expect re-rating as the Fed pushes the funds rate toward its equilibrium level, and we are alert to the certainty that stocks will de-rate sometime in the future if forward multiples are still subject to mean reversion. History shows it won’t necessarily happen in Phase I, though, and TINA may stave it off while there is a dearth of non-equity options offering positive prospective real returns. Disclaimer (BCA Is Human, Too) How can you be certain that your estimate of the equilibrium rate is accurate? We are not certain at all about the level of the equilibrium rate, and nothing we’ve ever written or said should be construed as implying that we are. As we’ve said many times before, the equilibrium rate is a concept. It cannot be directly observed and our attempts to estimate it are no more than our best effort to gain a sense of where the tipping point for financial markets and the economy might be. Our current 3.25% estimate likely sounds quite high, but we take the estimates at any given point in time with a grain of salt. We are not so full of ourselves that we believe we can pin down an amorphous concept to two decimal places in real time, and we have found that thinking of the point estimate as falling within a plausible range is the best way to proceed. Right now, the US Investment Strategy team views the equilibrium rate as somewhere around 2.5% or higher. That’s all the precision we need to assert with high conviction that monetary policy is accommodative and will remain so for all of 2022 and much, if not all, of 2023. For all the inherent uncertainty of attempts to quantify the equilibrium rate, however, the sharp disparity in equity performance across easy and tight monetary policy settings suggests that we’re on the right track. We’re further encouraged by the clear distinctions in earnings and multiples growth across phases (Figure 1), which suggest that monetary policy settings exert a persistent influence on fundamentals and investor appetites. Given that equities have flourished when policy is easy, overweighting stocks in multi-asset portfolios should contribute to outperformance over the next twelve months. Monetary policy settings are not the be-all and the end-all, but we have found that they offer a very useful default guide to asset allocation. Fooled By Randomness? The results have been robust over a lengthy period, but how do you know they’re not random? Why does the relationship you’ve cited work? We are convinced that the observed strong-growth/tighter-policy, tepid-growth/easier-policy relationship has a durable structural foundation. The through line is the fact that monetary policy is a blunt instrument that works with indeterminate lags. Its limitations influence the way the Fed deploys it and impose a predictable pattern on its economic and market impacts. The Fed is not quite the meddler that its Libertarian-minded critics make it out to be, hovering over the economy in a continuous effort to fine-tune it. Instead, it acts on a limited basis to ensure that the harms embedded in cyclical extremes do not prevent the economy from reaching its long-run potential. It deploys accommodative measures during recessions to keep hysteresis from turning a cyclical soft patch into a structural albatross and restrictive measures during high-revving expansions to keep the inflation genie from getting out of the bottle. The Fed does not want to root out green shoots before they can take hold, so it does not begin Phase I, or assiduously pursue it, until it is certain that the economy can withstand higher rates, especially while (lagging) inflation readings are tame (Chart 3). It therefore launches tightening cycles with a predictable bias to err on the side of being too easy. Chart 3Inflation Is A Lagging Indicator, ... That bias allows the economy to gather momentum in Phase I, in line with cyclical peaks in activity and earnings growth, and outsized equity and credit returns. Left unchecked, the momentum could produce higher inflation, and the Fed is typically compelled to dial up intervention to counter it. Wielding a blunt instrument that works with a lag, however, the Fed is at risk of going too far, and Phase II hikes often induce a recession. Investors sniff out the looming downturn and de-rate equities. By the time the Fed reverses field and initiates a new easing campaign (Phase III), earnings growth has stalled out and measured inflation is peaking (Table 3). Equities mark time and credit spreads widen until, with a slowdown plainly evident and measured inflation sliding, the Fed shifts to full-on accommodation (Phase IV). It maintains market-friendly settings until the economy begins to look too strong, upon which it intervenes to hold it back, kicking off a new policy cycle. Table 3... Managed With Policy That Works With A Lag As we showed last week, the direct relationship between activity and rates is immediately apparent in the real economy. Robust activity translates to robust earnings growth, but it is possible that equity multiples will behave differently in the approaching fed funds rate cycle than they have in the past. Although we expect that TINA will protect equities from meaningful de-rating pressure this year, investors should not lose sight of the fact that the earnings estimate era began with the S&P 500’s forward P/E multiple at 7. That rock-bottom starting point paved the way for an annualized 2.6% valuation increase over the last 42 years, but it cannot continue indefinitely, if at all. We are confident that multiples will continue to fare better when the Fed is cutting rates than when it is hiking them, but the cutting tailwinds will likely weaken going forward, while the hiking headwinds will stiffen. Don’t Believe The Hype Tech stocks are especially vulnerable to higher interest rates and the fate of US indexes is intimately bound up with them. Aren’t you dismissing the threat from higher rates a little too easily? The Tech sector’s outsized presence in the S&P 500 has surely contributed to market anxieties over looming rate hikes. We are firmly of the view, however, that popular concerns over Tech stocks’ interest rate vulnerability are way overdone. The idea that their back-loaded earnings profile makes them acutely vulnerable to a higher discount rate in the manner of long duration bonds ignores the fact that their future cash flows are not fixed. Unlike bonds, their owners' claims on earnings ebb and flow as rates rise and fall in line with economic conditions. Chart 4Relative Tech Multiples Have Mostly Moved With Rates, Not Against Them We recently devoted a Special Report to pushing back against the idea that Tech stocks are hostage to interest rates. In it, we argued that a stock’s price can be viewed as the product of its earnings per share and its P/E ratio. The biggest Tech companies’ earnings have a low interest rate sensitivity because they have little debt and do not sell big-ticket items that their customers have to finance, so the purported inverse relationship between Tech stocks’ relative performance and interest rates must be a function of relative P/E multiple changes. Relative Tech multiples and interest rates consistently moved together in the ten years through 2018, however, and were only sporadically negatively correlated over the last three years (Chart 4). Duration is essential for describing the sensitivity of risk-free bond returns to changes in interest rates, but it is an uncomfortable fit with equities. Treasuries exhibit a nearly perfect inverse correlation with changes in interest rates (Chart 5, top panel), but the cash flow uncertainty introduced by even the modest credit risk associated with investment grade corporate bonds reduces the correlation considerably (Chart 5, second panel). Interest rates’ impact on equities is even more attenuated. The S&P 500 is only weakly – and positively – correlated with rates (Chart 5, third panel), just like its Tech sector constituents (Chart 5, bottom panel).                Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Highlights The most important question is whether the Fed will hike interest rates by more than what is currently discounted in markets, or less. More hikes will trigger a set of cascading reactions. US bond yields will initially jump, boosting the dollar. But this process could also undermine growth stocks, and the US equity market leadership. Equity portfolio flows have been more important in financing the US trade deficit, than Treasury purchases, since 2020. Hence, a reversal in these flows will undermine a key pillar of support for the dollar. On the flip side, less rate hikes will severely unwind higher interest rate expectations in the US vis-a-vis other developed markets, especially in the euro area and Japan. This means we could be witnessing a shift in the dollar, where upside is capped, and downside is substantial. Feature Chart 1The Dollar In 2021 The two most important drivers of the dollar over the last few months have been the spread between US interest rates and other developed markets, as well as the relative performance of US equities (Chart 1). Rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. The outperformance of the US equity market has also coincided with notable portfolio inflows into US equities in 2021. This cocktail of macro drivers has pinned the US dollar in a quandary. If rates rise substantially in the US, and that undermines the US equity market leadership, the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. The Dollar And The Equity Market The traditional relationship between the dollar and the equity market was negative for most of the first half of the pandemic. Monetary easing by the Federal Reserve stimulated global financial conditions setting the stage for an epic bull market. The correlation between the S&P 500 and the DXY index was a near perfect inverse correlation for much of 2020 (Chart 2). Chart 3US Equity Portfolio Inflows Have Been Substantial Since 2020 Chart 2The Dollar In ##br##2020 The big change in 2021 is that this correlation has shifted, as the Fed has pivoted on monetary policy. This means that investors have been betting on higher stock prices in the US, as well as higher interest rates. In short, portfolio flows into US equities have surged (Chart 3). For the long-duration US equity market, higher interest rates could push it to a tipping point, where it starts to underperform other developed market bourses. This will reverse these equity portfolio flows, hurting the dollar in the process. Profits, Interest Rates And The Dollar The key driver of equity markets is profits in the short run, with valuation starting to matter over the longer run. This in turn becomes the key driver of cross-border equity flows. These flows help dictate currency movements. For much of the previous decade, US profits did much better than overseas earnings. For this reason, the US equity market outperformed, pulling the dollar up, as foreign equity purchases accelerated (Chart 4). The post-pandemic era has seen inflation rising across the world, changing the paradigm for US profits. High inflation, and consequently, higher bond yields, have been synonymous with an underperformance of US profits (Chart 5). Banks profit from higher rates, as they benefit from rising net interest margins. Materials, energy, and industrial stocks, benefit from higher inflation via rising commodity prices that boost their pricing power. In a nutshell, rising inflation tends to be better for value stocks and cyclicals, sectors that are underrepresented in the US. This means portfolio flows into US equities, one of the key drivers of the capital account surplus, could be on the cusp of a substantial reversal. Chart 4The Dollar And Relative Profits Chart 5Bond Yields And Relative Profits Second, valuation in the US has become extended as interest rates have fallen. More importantly, US valuations have been more sensitive to changes in interest rates, compared to other developed markets (Chart 6). This is because the US stock market has become increasingly overweight long duration sectors, like technology and healthcare. Higher rates will undermine the valuation premium these sectors command. This will cause the US equity market to derate relative to other cyclical bourses. Chart 6Relative Multiples And Bond Yields The key point is that the US equity market has been the darling of the last decade, and leadership is at risk from higher rates, via a reset in both relative valuation and relative profits. So, while the US market could perform well in 2022, higher rates could undermine its relative performance to overseas bourses. This will curtail equity portfolio inflows, as capital tends to gravitate to markets with higher expected returns. The Dollar And Relative Interest Rates Over the long term, bond flows are the overarching driver of the currency market. Most market participants expect the Fed to be among the most hawkish in 2022. This is clear in the pricing of the Eurodollar versus Euribor December 2022 contract, or just the relative path of two-year US bond yields versus other markets. This in turn has helped drive speculative positioning in the US dollar towards record highs (Chart 7). Correspondingly, US Treasury inflows have accelerated in recent months, even though real interest rates have not risen that much (Chart 8). In level terms, the trade deficit (that hit a record low of -US$80bn in November) is being helped financed by renewed foreign interest in US Treasurys. Chart 8Interest Rates And Treasury Flows Chart 7Record Dollar Speculative Positions We see two major contradictions in the pricing of US interest rates, relative to other developed markets. First, rising inflation is a global phenomenon and not specific to the US. If inflation proves sticky, other central banks will turn a tad more hawkish to defend their policy mandates. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. This will unwind speculative long positions in the dollar. It will also slow portfolio inflows into US Treasuries. Second, the reality is that outside the ECB and the BoJ, most other developed market central banks have already tightened monetary policy ahead of the Fed. The ability of any central bank to tighten policy will depend on the health of the labor market, and the potential for a wage inflation spiral. One data point that has caught our attention is the participation rate across G10 economies - it is notable that the US has one of the lowest participation rates (Chart 9A). Given that many countries have seen their participation rate recover to pre-pandemic levels, it suggests upside in the US rate. This will be especially the case if fiscal stimulus, which could wane, has been a key reason why the US participation rate has stayed low. In a nutshell, the low participation rate in the US could be a reason the Fed lags market expectations for aggressive rate increases this year. On the flip side, a higher participation rate in places like Canada, Norway, and Australia, could allow their central banks to normalize policy faster than the market expects. There has been a loose correlation between relative changes in the participation rate, and relative changes in inflation across G10 economies (Chart 9B).  Chart 9BThe US Relative Participation Rate And Relative Inflation Chart 9AUS Labor Force Participation Is Low, But Improving Finally, relative monetary policy tends to be driven by relative growth. US growth remains robust but has been rolling over relative to other developed markets (Chart 10). This is occurring at a time when China is easing monetary policy, which tends to buffet non-US growth. Higher non-US growth could also tip the bond and currency market narrative that the Fed will tighten much faster than other G10 central banks. Chart 10Non-US Growth Is Improving, Relative To US Growth Conclusion The above analysis suggests we could be entering a paradigm shift in the dollar, where any response by the Fed could eventually trigger the same outcome. Higher rates than the market expects will initially boost the US dollar. But this process will also undermine the US equity market leadership, reversing substantial portfolio inflows in recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US vis-a-vis other developed markets. Our concluding thoughts from our 2022 outlook, which are consistent with our views herein, were as follows: The DXY could touch 98 in the near term but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a currency basket of oil producers versus consumers. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar. The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights The neutral rate of interest in the US is 3%-to-4% in nominal terms or 1%-to-2% in real terms, which is substantially higher than the Fed believes and the market is discounting. The end of the household deleveraging cycle, rising wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand. In addition, deglobalization and population aging are depleting global savings, raising the neutral rate in the process. A higher neutral rate implies that monetary policy is currently more stimulative than widely perceived. This is good news for stocks, as it reduces the near-term odds of a recession. The longer-term risk is that monetary policy will stay too loose for too long, causing the US economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Investors should overweight stocks in 2022 but look to turn more defensive in late 2023. We are taking partial profits on our long December-2022 Brent futures trade, which is up 17.3% since inception. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it.  The Neutral Rate Matters At first glance, the neutral rate of interest – the interest rate consistent with full employment and stable inflation – seems like a concept only an egghead economist would care about. After all, unlike actual interest rates, the neutral rate cannot be observed in real time. The best one can do is deduce it after the fact, something that does not seem very relevant for investment decisions. While this perspective is understandable, it is misguided. The yield on a long-term bond is largely a function of what investors expect short-term rates to be over the life of the bond. Today, investors expect the Fed to raise rates to only 1.75% during this tightening cycle, a far cry from previous peaks in interest rates (Chart 1). Chart 2Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Chart 1Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates     Far from worrying that the Fed will keep rates too low for too long in the face of high inflation, investors are worried that the Fed will tighten too much. This is the main reason why the yield curve has flattened over the past three months and the 20-year/30-year portion of the yield curve has inverted (Chart 2). Secular Stagnation Remains The Consensus View Why are so many investors convinced that the Fed will be unable to raise rates all that much over the next few years? The answer is that most investors have bought into the secular stagnation thesis, which posits that the neutral rate of interest has fallen dramatically over time. The secular stagnation thesis comes in two versions: The first or “strong form” describes an economy that needs a deeply negative – and hence unattainable – nominal interest rate to reach full employment. Japan comes to mind as an example. The country has had near-zero interest rates since the mid-1990s; and yet it continues to suffer from deflation. The second or "weak form" describes the case where a country needs a low, but still positive, interest rate to reach full employment. Such an interest rate is attainable by the central bank, and hence creates a goldilocks outlook for investors where profits return to normal, but asset prices continue to get propped up by an ultra-low discount rate. The “weak form” version of the secular stagnation thesis arguably describes the United States. Post-GFC Deleveraging Pushed Down The Neutral Rate One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If something causes the aggregate demand curve to shift inwards, a lower real interest rate would be required to bring demand back up (Chart 3). Like many other countries, the US experienced a prolonged deleveraging cycle following the Global Financial Crisis. The ratio of household debt-to-GDP has declined by 23 percentage points since 2008. The need for households to repair their balance sheets weighed on spending, thus necessitating a lower interest rate. Admittedly, corporate debt has risen over the past decade, with the result that overall private debt has remained broadly stable as a share of GDP (Chart 4). However, the drag on aggregate demand from declining household debt was not offset by the boost to demand from rising corporate debt. Whereas falling household debt curbed consumer spending, rising corporate debt did little to boost investment spending. This is because most of the additional corporate debt went into financial engineering – including share buybacks and M&A activity – rather than capex. In fact, the average age of the private-sector capital stock has increased from 21 years in 2010 to 23.4 years at present (Chart 5). Chart 4Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Chart 5The Average Age Of Capital Stock Has Been Increasing Buoyant Consumer And Business Spending Will Prop Up The Neutral Rate Today, the US economy finds itself in a far different spot than 12 years ago. Households are borrowing again. Consumer credit rose by $40 billion in November, the largest monthly increase on record, and double the consensus estimate (Chart 6). Banks are easing lending standards across all consumer loan categories (Chart 7). Chart 6Big Jump In Consumer Credit Chart 7Banks Are Easing Lending Standards For All Consumer Loans Chart 8Net Worth Has Soared Over The Past Two Years Meanwhile, years of easy money have pushed up asset prices, a dynamic that was only supercharged by the pandemic. We estimate that household wealth rose by 145% of GDP between the end of 2019 and the end of 2021 – the largest two-year increase on record (Chart 8). A back-of-the-envelope calculation suggests that this increase in wealth could boost aggregate demand by 5%.1 Reacting to the prospect of stronger final demand, businesses are ramping up capex (Chart 9). After moving sideways for two decades, capital goods orders have soared. Surveys of capex intentions remain at elevated levels. Against the backdrop of empty shelves and warehouses, inventory investment should also remain robust. Residential investment will increase (Chart 10). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 10-month high in December. Building permits are 11% above pre-pandemic levels. Amazingly, homebuilders are trading at only 7-times forward earnings. We recommend owning the sector. Chart 9Investment Spending Will Stay Strong Chart 10US Housing Will Remain Well Supported Fiscal Policy: Tighter But Not Tight Chart 11Chinese Credit Impulse Seems To Be Bottoming As in most other countries, the US budget deficit will decline over the next few years, as pandemic-related measures roll off and tax receipts increase on the back of a strengthening economy. Nevertheless, we expect the structural budget deficit to remain 1%-to-2% of GDP larger in the post-pandemic period, following the passage of the infrastructure bill last November and what is likely to be a slimmed down social spending package focusing on green energy, universal pre-kindergarten, and health insurance subsidies. The shift towards structurally more accommodative fiscal policies will play out in most other major economies. In the euro area, spending under the Next Generation EU recovery fund will accelerate later this year, with southern Europe being the primary beneficiary. In Japan, the government has approved a US$315 billion supplementary budget. Matt Gertken, BCA’s Chief Geopolitical Strategist, expects Prime Minister Kishida to pursue a quasi-populist agenda ahead of the upper house election on July 25th.  China is also set to loosen policy. The Ministry of Finance has indicated that it intends to “proactively” support growth in 2022. For its part, the PBoC cut the reserve requirement ratio by 50 basis points on December 6th. The 6-month credit impulse has already turned up (Chart 11). More Than The Sum Of Their Parts Chart 12The Labor Share Typically Rises When Unemployment Falls As discussed above, the end of the deleveraging cycle, rising household wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand in the US. While each of these factors have independently raised the neutral rate of interest, taken together, the impact has been even greater. For example, stronger consumption has undoubtedly incentivized greater investment by firms eager to expand capacity. Strong GDP growth, in turn, has pushed up asset prices, leading to even more spending. Furthermore, a tighter labor market has propped up wage growth, especially among low-wage workers. Historically, labor’s share of overall national income has increased when unemployment has fallen (Chart 12). To the extent that workers spend more of their income than capital owners, a higher labor share raises aggregate demand, thus putting upward pressure on the neutral rate. The Retreat From Globalization Will Push Up The Neutral Rate… Chart 13The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade Globalization lowered the neutral rate of interest both because it shifted the balance of power from workers to businesses; and also because it allowed countries such as the US, which run chronic current account deficits, to import foreign capital rather than relying exclusively on domestic savings.  The era of hyperglobalization has ended, however. The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 13). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. … As Will Population Aging Chart 14Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Aging populations can affect the neutral rate either by dragging down investment demand or by reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 14 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades. In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 15). As baby boomers transition from net savers to net dissavers, national savings will fall, leading to a higher neutral rate. The pandemic has accelerated this trend insomuch as it has caused about 1.2 million workers to retire earlier than they would have otherwise (Chart 16). Chart 16Number Of Retired People Jumped During The Pandemic To What Extent Are Higher Rates Self-Limiting? Some commentators contend that any effort by central banks to bring policy rates towards neutral would reduce aggregate demand by so much that it would undermine the rationale for why the neutral rate had increased in the first place. In particular, they argue that higher rates would drag down asset prices, thus curbing the magnitude of the wealth effect. While there is some truth to this argument, its proponents overstate their case. History suggests that stocks tend to brush off rising bond yields, provided that yields do not rise to prohibitively high levels (Table 1). Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Chart 17The Equity Risk Premium Remains High The last five weeks are a case in point. Both 10-year and 30-year Treasury yields have risen nearly 40 bps since December 3rd. Yet, the S&P 500 has gained 2.7% since then. Keep in mind that the forward earnings yield for US stocks still exceeds the real bond yield by 552 bps, which is quite high by historic standards. The gap between earnings yields and real bond yields is even greater abroad (Chart 17). Thus, stocks have scope to absorb an increase in bond yields without a significant PE multiple contraction. Investment Implications Our analysis suggests that the neutral rate of interest in the US is substantially higher than widely believed. How much higher is difficult to gauge, but our guess is that in real terms, it is between 1% and 2%. This is substantially higher than survey measures of the neutral rate, which peg it at close to 0% in real terms (Chart 18). It is also significantly higher than 10-year and 30-year TIPS yields, which stand at -0.73% and -0.17%, respectively (Chart 19). The neutral rate has also increased in other economies, although not as much as in the US. Chart 18Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Chart 19Long-Term Real Rates Remain Depressed If the neutral rate turns out to be higher than the consensus view, then monetary policy is currently more stimulative than widely perceived. That is good news for stocks, as it would reduce the near-term odds of a recession. Hence, we remain positive on stocks over a 12-month horizon, with a preference for non-US equities. In terms of sector preferences, we maintain our bias for banks over tech. The longer-term risk is that monetary policy will stay too easy, causing the economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Such a day of reckoning could be reached by late 2023. Two Trade Updates We are taking partial profits on our long December-2022 Brent futures trade by cutting our position by 50%. The trade is up 17.3% since inception. Bob Ryan, BCA’s Chief Commodity Strategist, still sees upside for oil prices, so we are keeping the other half of our position for the time being. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it. While the outlook for both companies remains challenging, there is an outside chance that they will find a way to leverage their meme status to create profitable businesses. This makes us inclined to move to the sidelines.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 In line with published estimates, we assume that households spend 5 cents of every one dollar increase in housing wealth, 2 cents of every dollar increase in equity wealth, 10 cents out of bank deposits, and 2 cents out of other assets. Of the 145% of GDP in increased household net worth between the end of 2019 and the end of 2021, 19% stemmed from higher housing wealth, 52% from higher equity wealth, 12% from higher bank deposits, and 17% from other categories.    View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights 2022 Key Views & Allocations: Translating our 2022 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions to begin the year. Target a moderate level of overall portfolio risk, maintain below-benchmark overall duration exposure, make developed market government bond country allocations based on relative expected central bank hawkishness (underweight the US, UK and Canada; overweight Germany, France, Italy, Australia, Japan), and be selective on allocations to global spread product (overweight high-yield with a bias toward Europe over the US, neutral global investment grade, underweight emerging market hard currency debt). Specific Allocation Changes: Much of the current positioning in our model bond portfolio already reflects our 2022 investment themes. The only significant changes we make to begin the year are reducing emerging market USD-denominated corporate bond exposure to underweight, and shifting some high-yield corporate bond exposure from the US to Europe. Feature In our last report of 2021, we published our 2022 Key Views, outlining the themes and investment implications of the 2022 BCA Outlook for global fixed income markets. In this report, our first of the new year, we translate those views into more specific recommendations and allocations within the BCA Research Global Fixed Income Strategy model bond portfolio. The main takeaways are that another year of expected above-trend global growth, even after the risks to start the year from the Omicron variant, will further absorb spare capacity across the developed economies. Realized inflation will slow from the elevated readings of 2021, but will remain high enough to force central banks – led by the US Federal Reserve – to incrementally remove highly accommodative monetary policies put in place during the pandemic. The backdrop for global bond markets will turn far less friendly as a result, with higher bond yields (led by US Treasuries), flatter yield curves and much weaker returns on spread products that have benefited from easy monetary policies like investment grade corporate debt and emerging market (EM) hard currency debt. Against this challenging backdrop for overall fixed income returns, bond investors will need to focus more on relative exposures between countries, sectors and credit ratings to generate outperformance versus benchmarks. Our recommended portfolio allocations to begin 2022 reflect that shift (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The Model Bond Portfolio Performance In 2021 Chart 12021 Performance: A Positive, Yet Volatile, Year Before we begin our discussion of the model bond portfolio for 2022, we will take a final look back at the performance of the portfolio in 2021. Last year, the model bond portfolio delivered a small negative total return (hedged into US dollars) of -0.51%, but this still outperformed its custom benchmark index by +36bps (Chart 1).1 It was a very challenging year for global fixed income markets, in aggregate, with significant swings in bond yields (i.e. US Treasuries were up in Q1, down in Q2/Q3, up then down in Q4) and credit spreads (US high-yield spreads fell in H1/2021 and were rangebound in H2/2021, while EM hard currency spreads were stable in H1/2021 before steadily widening during the rest of the year). Over the full year, the government bond portion of the portfolio outperformed the custom benchmark index by +27bps while the spread product segment outperformed by +9bps (Table 2). The bulk of that government bond outperformance occurred during the first quarter of the year when global bond yields surged higher as COVID-19 vaccines began to be distributed and economic optimism improved in response – trends that benefited the below-benchmark duration tilt within the portfolio. The credit market outperformance was more evenly spread out during the final nine months of the year. Table 2GFIS Model Bond Portfolio Full Year 2021 Overall Return Attribution In terms of specific country exposures on government debt (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) generated virtually all of the full-year outperformance of the government bond portion of the portfolio (+38bps versus the benchmark). The biggest underperformer was the UK (-9bps), concentrated at the very end of the year as Gilt yields declined on the back of the Omicron surge, to the detriment of our underweight stance. All other country allocations provided little excess return, in aggregate, over the full year in 2021 – although there was significant variance of those returns during the year. Within spread product (Chart 3), the biggest gains were seen in US high-yield (+19bps) where we remained overweight throughout 2021. The largest drag on performance came from UK investment grade corporates (-9bps), although this all came in Q1/2021 where we maintained an overweight stance at the time and spreads widened. Other spread product sectors delivered little in the way of excess return, although that should not be a surprise as we maintained a neutral stance on US and euro area investment grade corporates – which have a combined 18% weighting within the model bond portfolio custom benchmark index – throughout 2021. In the end, our recommended portfolio tilts during 2021 were generally on the right side of the market, with our overweights outperforming in an overall down year for bond returns (Chart 4). The numbers would have been even better without the drag on performance in the fourth quarter (-17bps for the entire portfolio). That came entirely from our two biggest government bond underweights – US Treasuries and UK Gilts – which saw significant bond yield declines in response to the emergence of the Omicron variant. (the detailed breakdown of the Q4/2021 performance can be found in the Appendix on pages 19-23). Importantly, the surge in bond yields seen in the first week of 2022 has already resulted in a full recovery of that Q4/2021 underperformance, providing a good start to the new year for our model portfolio. Top-Down Bond Market Implications Of Our Key Views We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: BELOW BENCHMARK As we concluded in our 2022 Key Views report, longer-maturity government bond yields are now too low given the mix of very high inflation and very low unemployment seen in many countries. While we expect inflation to come down this year from the very rapid pace of 2021, it will not be by enough to force central banks off the path towards rate hikes that already began at the end of last year in places like the UK and New Zealand. The Fed is now signaling that multiple US rate hikes are likely in 2022, while even some European Central Bank (ECB) officials are expressing concern over very high European inflation. Longer maturity bond yields remain too low, in our view, because investors are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. (Chart 5). An upward adjustment of global interest rate expectations is likely this year as central banks like the Fed and the Bank of England (BoE) deliver on expected rate hikes, with more tightening necessary beyond 2022. This will be the primary driver of the rise in global bond yields that we expect this year - an outcome that has already begun in the first week of 2022. Chart 5Global Government Bond Yields Vulnerable To Hawkish Repricing​​​​​​ Chart 6Staying Below-Benchmark On Overall Duration Exposure​​​​​​ We ended 2021 with a model bond portfolio duration that was -0.65 years below that of the custom performance benchmark (Chart 6). We feel comfortable maintaining that position, in that size, to begin the new year. Government Bond Country Allocation: OVERWEIGHT THE EURO AREA (CORE & PERIPHERY), JAPAN & AUSTRALIA; UNDERWEIGHT THE US, UK & CANADA Our country allocation decisions within our model bond portfolio entering 2022 are based on a simple framework. We are overweighting countries where central banks are less likely to raise rates this year, and vice versa. We expect the largest increase in developed market bond yields in 2022 to occur in the US, as markets are still not priced for the cumulative tightening that the Fed will likely deliver over the next couple of years. Markets are also underpricing how much the Bank of England and Bank of Canada will need to raise rates over the full tightening cycle, even with multiple hikes discounted for 2022. We see the necessary upward repricing of post-2022 rate expectations in all three of those countries – the US, UK and Canada – justifying underweight allocations in our model portfolio. Chart 7Our Recommended DM Government Bond Allocations To Start 2022 The opposite is true in core Europe and Australia. Overnight index swap (OIS) curves are discounting multiple rate hikes this year from the Reserve Bank of Australia (RBA) and even an ECB rate hike later in 2022. As we discussed in our Key Views report, there is still not enough evidence pointing to rapid wage growth in Australia or Europe that would force the RBA and ECB to turn more hawkish than their current forward guidance which calls for no rate hikes in 2022. While both central banks may talk about the possibility that monetary policy will need to be tightened, we expect the actual rate hikes to occur in 2023 and not 2022. Thus, both markets justify overweight allocations in our model bond portfolio. We are also maintaining an overweight to Japanese government bonds, as Japanese inflation remains far too low – even in an environment of high energy prices and global supply chain disruption – for the Bank of Japan to contemplate any tightening of monetary policy. The country allocations within the model portfolio as of the end of 2021 all fit with the above analysis, thus we see no major changes that need to be made to begin 2022 (Chart 7).2 The only significant move made was to slightly bump up the size of the overweights in Italy and Spain, to be funded by the reduction in EM corporate bond exposure (as we discuss below). We continue to see a positive case for owning Peripheral European government bonds for the relatively high yields within Europe, with the ECB maintaining an overall dovish policy stance in 2022 even as it scales back the size of its bond buying activity starting in March. Inflation-Linked Bond Allocations: MAINTAIN A NEUTRAL OVERALL ALLOCATION TO GLOBAL LINKERS Chart 8Our Recommended Inflation-Linked Bond Allocations To Start 2022 Inflation-linked bonds have been a necessary part of bond investors' portfolios since the lows in global inflation breakeven spreads were seen in mid-2020. Now, with inflation expectations at or above central bank inflation targets in most developed market countries, and with realized inflation likely to subside from current levels this year, the backdrop no longer justifies structural overweights to linkers across all countries. We are sticking with our end-2021 overall neutral allocation to global inflation-linked bonds, focusing more on country allocations based on our inflation breakeven valuation indicators, as discussed in our 2022 Key Views report (Chart 8). This means maintaining a neutral stance on US TIPS and linkers (vs. nominal government bonds) in Canada, Australia and Japan. We are also staying with underweight positions in linkers (vs. nominals) in the UK, Germany, France and Italy where breakevens appear too high based on our indicators. Spread Product Allocation: MAINTAIN A SMALL OVERWEIGHT TO GLOBAL SPREAD PRODUCT FOCUSED ON EUROPEAN & US HIGH-YIELD CORPORATES, WHILE UNDERWEIGHTING EM CREDIT Chart 9Negative Real Yields: Global Bonds' Biggest Vulnerability Our expectation of above-trend global growth in 2022, with still relatively high inflation (compared to pre-pandemic levels), should be positive for spread products like corporate bonds that benefit from strong nominal economic (and revenue) growth. However, the less accommodative global monetary policy backdrop we also expect is a potential negative for credit market performance - specially as rate hikes put upward pressure on deeply negative real interest rates, most notably in the US (Chart 9). Thus, we are entering 2022 with a cautious, but still positive, overall position on spread product in our model bond portfolio. We are focusing more on credit valuation, however - both in absolute terms and between countries and sectors – to try and generate outperformance for the credit portion of the portfolio. We are maintaining a neutral stance on investment grade corporates in the US, euro area and UK given the tight spread valuations in those markets. We prefer to focus our corporate credit exposure on overweights to high-yield bonds in the US and Europe, but with a marginal preference for European junk bonds over US equivalents as we discussed in our 2022 Key Views report (Chart 10). Within EM USD-denominated credit, we remain cautious entering 2022 given the poor fundamental backdrop for EM credit: slowing momentum of Chinese economic growth and global commodity prices, a firmer US dollar, and a less-accommodative global monetary policy backdrop (Chart 11). Thus, an underweight stance on EM credit is appropriate within the portfolio to start the year. Chart 10Increase Euro High-Yield Exposure Vs US High-Yield Chart 11Reduce EM USD-Denominated Corporate Debt Exposure To Underweight​​​​​​   Finally, we are entering 2022 with the same relative tilt within US mortgage-backed securities (MBS) that we maintained during the latter half of 2021, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Based on our outlook for 2022, we are immediately making two marginal changes to the spread product allocations to the model bond portfolio: Reducing the size of our US high-yield overweight and using the proceeds to increase the size of the European high-yield overweight Reducing our EM USD-denominated corporate bond allocation to underweight from neutral, and placing the proceeds into Italian and Spanish government bonds (hedged into USD) to limit the reduction in the portfolio yield from the EM downgrade. The above moves will lower our overall credit overweight versus government bonds from 5% to 4%, all coming from the EM to Italy/Spain switch (Chart 12). Overall Portfolio Risk: MODERATE The changes made to our spread product allocations had no material impact on the estimated tracking error of the model portfolio – the relative volatility versus that of the benchmark. The tracking error is 78bps, still below our self-imposed limit of 100bps but above the lows seen in early 2021 (Chart 13). That higher tracking error is likely related to our underweight stance on US Treasuries, given the rise in bond volatility evident in measures like the MOVE index (bottom panel). Nonetheless, a moderate level of portfolio risk is reasonable given the combination of solid global economic growth, but with tighter global monetary policy, that we expect in 2022. Chart 13Keeping Overall Portfolio Risk At Moderate Levels​​​​​​ Chart 14Positive Portfolio Carry Via Selective Spread Product Overweights​​​​​​ The overweights to US high-yield, European high-yield and Italian government bonds all contribute to the model bond portfolio having a yield that begins 2022 modestly higher (+14bps) than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making all the changes to our model portfolio allocations, which can be seen in the tables on pages 24-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio during the first half of 2022. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case Omicron related economic weakness is visible in some major economies (euro area, Canada), but the US stays resiliently strong and the US labor market continues to tighten. China is a growth laggard, but this will lead to policymakers providing more macro stimulus (credit, monetary, fiscal) starting in Q2/2022. Inflation pressures from supply chain disruption remain stubbornly strong and realized global inflation rates stay elevated for longer. Developed market central banks continue dialing back pandemic-era monetary policy accommodation, led by Fed tapering and a June 2022 liftoff of the funds rate. There is a mild initial bear steepening of the US Treasury curve with additional widening of US inflation breakevens in Q1/2022, leading to bear flattening in Q2 in the run-up to liftoff – the net effect is a parallel shift higher in the entire yield curve. The VIX index stays near current levels at 20, both the US dollar and oil prices are broadly unchanged and the fed funds rate is increased to 0.25%. Hawkish Fed The Omicron wave is short-lived with limited impact on global growth, which remains well above trend. Global inflation only declines moderately from current elevated levels, both from persistent supply squeezes and faster wage growth. China loosens monetary/credit policies and announces new fiscal stimulus in late Q1/2022 – a positive surprise for global growth expectations. Developed economy central banks turn even more hawkish. Fed liftoff is in March, with another hike in June. The US Treasury curve bear-flattens as US inflation breakevens reach their cyclical peak. The VIX index climbs to 25, the US dollar depreciates by -3% (pulled in opposing directions by strong global growth but relatively higher US interest rates), oil prices climb +10% and the fed funds rate is increased to 0.5%. Pessimistic Scenario The Omicron wave persists in many major countries (including the US) and leads to extended lockdowns and weaker consumer spending. Global growth momentum slows sharply. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration passes much smaller US fiscal stimulus. Supply chain disruptions persist and are made worse by Omicron, keeping inflation elevated even as growth slows (stagflation). Developed economy central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to economic weakness. The Fed goes for a slower taper that still ends in June, but liftoff is delayed until at least September. The US Treasury curve bull steepens modestly as the front end prices out 2022 hikes. US inflation breakevens remain sticky due to persistent realized inflation. The VIX index climbs to 30, the US dollar appreciates by +5% on a safe haven bid, oil prices fall -10% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Chart 15Risk Factor Assumptions For The Scenario Analysis​​​​​ Chart 16US Treasury Yield Assumptions For The Scenario Analysis​​​​​ The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +54bps in the Base Case and +31bps in the Hawkish Fed scenario, but is projected to underperform by -9bps in the Pessimistic scenario. Importantly, there is virtually no expected excess return from the credit side of model bond portfolio in the Hawkish Fed scenario, even with strong global growth. A faster-than-expected pace of Fed rate hikes in the first half of 2022 would be a clear signal to downgrade exposure to the riskier parts of the fixed income universe like US high-yield. Although in that Hawkish Fed scenario, greater-than-expected China stimulus and a weaker US dollar would also represent signals to begin adding back emerging market credit exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We also made very slight adjustments within the US, Japan, Germany and France allocations to refine our allocations across the various maturity buckets while keeping the overall portfolio duration unchanged entering 2022. Appendix Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Chart 1Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

Highlights The prospect of Fed rate hikes seems to be weighing on 2022 equity return expectations, … : Financial media outlets have been sounding the alarm about the impact of rate hikes on equity returns.  … but we think concerned investors are getting ahead of themselves, because monetary policy works with a lag, … : It takes time for changes in the fed funds rate to work their way through the economy. Even if the FOMC initiates a rate hike campaign in March, its effects may not begin to be felt until September or next March.  … and the fed funds rate is miles away from becoming restrictive: In inflation-adjusted terms, the entire interest rate structure is incredibly supportive of economic activity. Assuming 4% inflation, the real fed funds rate will still be well below the bottom of its 2013-19 range even if all of the rate hikes investors are currently discounting occur in 2022. We continue to believe that it is too soon to turn defensive in multi-asset portfolios: The bull markets in equities and credit will eventually end, but not while the FOMC is only beginning to unwind maximum monetary accommodation. Feature The release of the minutes from the FOMC’s December meeting momentarily roiled financial markets last week. The minutes had a distinctly hawkish tone, pointing to a mid-March liftoff date and raising the specter of a shrinking Fed balance sheet. The ensuing sell-off dovetailed with rising anxiety in the financial media about the potentially adverse equity market impacts of impending rate hikes. The opening two paragraphs of “The Big Uneasy” article that filled the front page of The New York Times’ Business section on New Year’s Day captured the prevailing tone:1 For two years, the stock market has been largely able to ignore the lived reality of Americans during the pandemic … because of underlying policies that kept it buoyant. Investors can now say goodbye to all that. The body of the article was much more measured, pointing out that a series of rate hikes would eventually slow the economy and could diminish investors’ near-term appetite for equities, before wrapping up with a wildly sensationalist quote. “The nightmare scenario is: The Fed tightens and it doesn’t help,” said Aaron Brown, a former risk manager of AQR Capital Management who now manages his own money and teaches math at [NYU]. Mr. Brown said that if the Fed could not orchestrate a “soft landing” for the economy, things could start to get ugly – fast. And then, he said, the Fed may have to take “very aggressive action like a rate hike to 15 percent, or wage and price controls, like we tried in the ‘70s.” By an equal measure, the Fed’s moves, even if they are moderate, could also cause a sell-off in stocks, corporate bonds and other riskier assets, if investors panic when they realize that the free money that drove their risk-taking to ever greater extremes over the past several years is definitely going away. Dennis Gartman, the longtime writer of a daily newsletter for traders and institutional investors, echoed the theme in an interview with Bloomberg Radio last Monday. The Bloomberg story summarizing the interview was headlined “Gartman Sees Stocks Falling 15% in 2022 on Aggressive Fed Hikes” and hewed to the higher-rates/lower-stocks mantra. “Gartman said … that stocks could trade 10% to 15% lower this year. While [he] has long been calling for a bear market, he said the catalyst for the decline could be the central bank raising interest rates amid a continued rise in inflation. … ‘The advent of a bear market will come when the Fed begins to tighten monetary policy, and that will be later this year. No question.’” We admired The Gartman Letter and subscribe to the Times, but fed funds rate concerns have gotten overdone. In our view, anxiety about the effect of rate hikes on equity returns in 2022 is misplaced on two counts. First, it ignores that monetary policy only impacts the economy with a lag. Second, it fails to distinguish between the level of the fed funds rate and its direction. The economy and the S&P 500 have historically thrived in the early stages of rate-hiking campaigns, meeting their Waterloo only after the level of the fed funds rate becomes restrictive. The Fed Funds Rate Cycle We formulate investment strategy based on our analysis of the cycles that exert the strongest pull on financial markets: the business cycle, the credit cycle and the monetary policy cycle. As applied to US markets, we have found that the monetary policy cycle has the most reliably meaningful impact. As shown in Figure 1, we decompose the cycle into four phases based on whether the FOMC is hiking (the left half of the curve) or cutting (the right half) rates and the position of the fed funds rate relative to our estimate of its equilibrium level (the dashed horizontal line). We deem policy to be accommodative when the funds rate is below equilibrium and restrictive when it is above equilibrium. We like to describe equilibrium as the fed funds rate that neither encourages nor discourages economic activity. The equilibrium rate is a concept and cannot be directly observed; though our estimate represents our best efforts, we recognize that no one can always pinpoint it in real time. We nonetheless take heart from the sharp divide in S&P 500 returns across periods that we have designated as easy or tight. As we show for the first time in this report, growth in key economic indicators aligns consistently with the progression of the funds rate cycle, supporting the investment conclusion that the approaching rate-hiking phase will be favorable for risk assets. Monetary Policy Works With A Lag The idea that monetary policy affects the economy with long and variable lags, first advanced by Milton Friedman in the late fifties, is universally accepted. To test the proposition within our policy cycle framework, we mapped growth in nonfarm payrolls, aggregate bank lending, consumption and GDP across rate cycle phases over the last 60 years. All series grew at their fastest rate in Phase I, when the Fed is tightening policy but has not yet made it tight. They continued to grow faster than their through-the-cycle pace, even when adjusted for inflation, in Phase II, when the Fed continues to hike the funds rate beyond its equilibrium level. Growth in Phases III and IV, when the Fed is easing policy to stimulate the economy, is markedly slower across all metrics than it is when the Fed is tightening. Chart 1 shows each indicator’s phase-by-phase performance in its own panel, with growth in early tightening Phase I (the solid black line) and late tightening Phase II (the dashed green line) easily surpassing early easing Phase III (the solid gray line) and late easing Phase IV (the dashed red line). Chart 1It Takes A While To Turn A Battleship, Especially When The Rudder Moves With Long And Variable Lags Table 1 fleshes out the results, reporting each metric’s compound annual growth rate (CAGR) across the phases and compiling the CAGRs when the Fed is hiking rates and when it's cutting them. It also presents the nominal growth rates for lending, consumption and GDP, which are not shown in the chart. We view the results as forcefully supporting the long-and-variable view, especially as the FOMC deliberately moves at an incremental pace so as not to act like Friedman’s fool in the shower.2 Given that Phase II growth is comfortably above trend for every metric, it appears that Phase I would have to move at hyperspeed to hobble the economy at any point over the next year-plus. Table 1Phase I Is The Economy's Growth Sweet Spot The Starting Point Matters, Too The economy should also be insulated from the adverse effects of reduced accommodation by virtue of its current level of support. The real fed funds rate is way below its financial crisis lows (Chart 2, top panel), along with the real 10-year Treasury yield (Chart 2, bottom panel). Both rates have steadily declined over the last 40 years' complete peak-to-peak cycles, in line with the US economy’s declining potential growth. Falling inflation has further contributed to a decline in the nominal equilibrium rate, as per the actual fed funds rate and our in-house estimate (Chart 3). Chart 2Real Rates Have A Long, Long Way To Go To Become Restrictive Chart 3Interest Rates May Have More Headroom Than Markets Think Our estimate bottomed well before the onset of the pandemic, however, and we would argue that the economy currently has far less need for monetary policy support than it did in the aftermath of the crisis. While the financial system reeled, Congress provided stingy fiscal support before taking it back like Lucy pulling the football away from Charlie Brown. In contrast, the US now has a surfeit of fiscal support and even WeWork founder Adam Neumann has ready access to capital. The upshot is that the rates tipping point is miles away and we doubt the Fed can cover that much ground in the space of one year. For Equities, Level Trumps Direction The level, not the direction, of the fed funds rate has driven US equity performance over the 60-year period covered by our equilibrium estimate. The S&P 500 has eked out a 0.4% nominal annualized return across the aggregate 19 years that policy has been tight, by our reckoning, while advancing 10.6% annually over the accumulated 41 years when it has been easy (Table 2). Easy policy’s ten-percentage-point advantage over tight policy leaves cutting rates’ four-point edge over hiking rates in the dust. Table 2Easy Policy Settings Yield An Extra 10 Percentage Points Of Nominal Returns, ...​​​​​​ Table 3... And An Extra 11.5 After Adjusting For Inflation​​​​​​ The easy/tight disparity widens to eleven-and-a-half percentage points when nominal returns are adjusted for inflation. In Phases I and IV, when the fed funds rate is below our estimate of equilibrium, the S&P 500 has generated robust 7.1% real annualized returns while shedding 4.4% in Phases II and III, when the funds rate exceeds our equilibrium estimate (Table 3). Stocks do better on a real basis when the Fed is cutting rates, just as they do on a nominal basis, but the spread is narrower. The level of rates is the key dividing line, not their direction. Investment Implications The empirical record overwhelmingly supports the idea that early-stage rate hikes will not stifle growth or prevent equities from generating ample positive excess returns over Treasuries and cash. Against a backdrop of high and soaring inflation that the economy has only faced twice in the last 50 years (Chart 4), however, it is worth considering whether this time could be different. Whereas most recent rate hike campaigns have patiently aimed to prevent potential inflation pressures from taking root in a robust economy, this one might require the Fed to move urgently to get the genie back in the bottle. Chart 4Be Careful What You Wish For, Central Bankers The potential for urgent rather than incremental action could turn the prevailing positive correlation between stock prices and interest rates negative, as our Chief Emerging Markets Strategist Arthur Budaghyan has warned. If inflation worries choke off animal spirits, multiple de-rating could more than offset typical Phase I earnings gains, sending stocks lower. Although we do not expect multiple contraction in 2022 given the dearth of asset classes with positive expected real returns, we see it as one of the major threats to our risk-friendly positioning. We will be watching out for it, along with adverse pandemic surprises and the possibility that consumption could disappoint, though we will stick with our constructive positioning in the meantime.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      "Fed’s Moves in 2022 Could End the Stock Market’s Pandemic Run", The New York Times (nytimes.com). Accessed January 3, 2022. 2     Friedman likened central banks to a person who excessively turns the hot or the cold tap in the shower when the water temperature does not change immediately, only to shock him/herself once the lag between action and effect closes.

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

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