Money/Credit/Debt

Highlights Biden’s first 100 days are characterized by a liberal spend-and-tax agenda unseen since the 1960s. It is not a “bait and switch,” however. Voters do not care about deficits and debt. At least not for now. The apparent outcome of the populist surge in the US and UK in 2016 is blowout fiscal spending. Yet the US and UK also invented and distributed vaccines faster than others. US growth and equities have outperformed while the US dollar experienced a countertrend bounce. While growth will rotate to other regions, China’s stimulus is on the wane. Of Biden’s three initial geopolitical risks, two are showing signs of subsiding: Russia and Iran. US-China tensions persist, however, and Biden has been hawkish so far. Our new Australia Geopolitical Risk Indicator confirms our other indicators in signaling that China risk, writ large, remains elevated. Cyclically we are optimistic about the Aussie and Australian stocks. Mexico’s midterm elections are likely to curb the ruling party’s majority but only marginally. The macro and geopolitical backdrop is favorable for Mexico. Feature US President Joe Biden gave his first address to the US Congress on April 28. Biden’s first hundred days are significant for his extravagant spending proposals, which will rank alongside those of Lyndon B. Johnson’s Great Society, if not Franklin Delano Roosevelt’s New Deal, in their impact on US history, for better and worse. Chart 1Biden's First 100 Days - The Market's Appraisal The global financial market appraisal is that Biden’s proposals will turn out for the better. The market has responded to the US’s stimulus overshoot, successful vaccine rollout, and growth outperformance – notably in the pandemic-struck service sector – by bidding up US equities and the dollar (Chart 1). From a macro perspective we share the BCA House View in leaning against both of these trends, preferring international equities and commodity currencies. However, our geopolitical method has made it difficult for us to bet directly against the dollar and US equities. Geopolitics is about not only wars and trade but also the interaction of different countries’ domestic politics. America’s populist spending blowout is occurring alongside a sharp drop in China’s combined credit-and-fiscal impulse, which will eventually weigh on the global economy. This is true even though the rest of the world is beginning to catch up in vaccinations and economic normalization. As for traditional geopolitical risk – wars and alliances – Biden has not yet leaped over the three initial foreign policy hurdles that we have highlighted: China, Russia, and Iran. In this report we will update the view on all three, as there is tentative improvement on the Russian and Iranian fronts. In addition, we will introduce our newest geopolitical risk indicator – for Australia – and update our view on Mexico ahead of its June 6 midterm elections. Biden’s Fiscal Blowout From a macro point of view, Biden’s $1.9 trillion American Rescue Plan Act (ARPA) was much larger than what Republicans would have passed if President Trump had won a second term. His proposed $2.3 trillion American Jobs Plan (AJP) is also larger, though both candidates were likely to pass an infrastructure package. The difference lies in the parts of these packages that relate to social spending and other programs, beyond COVID relief and roads and bridges. The Republican proposal for COVID relief was $618 billion while the Republicans’ current proposal on infrastructure is $568 billion – marking a $3 trillion difference from Biden. In reality Republicans would have proposed larger spending if Trump had remained president – but not enough to close this gap. And Biden is also proposing a $1.8 trillion American Families Plan (AFP). Biden’s praise for handling the vaccinations must be qualified by the Trump administration’s successful preparations, which have been unfairly denigrated. Similarly, Biden’s blame for the migrant surge at the southern border must be qualified by the fact that the surge began last year.1 A comparison with the UK will put Biden’s administration into perspective. The only country comparable to the US in terms of the size of fiscal stimulus over 2019-21 so far – excluding Biden’s AJP and AFP, which are not yet law – is the United Kingdom. Thus the consequence of the flare-up of populism in the Anglo-Saxon world since 2016 is a budget deficit blowout as these countries strive to suppress domestic socio-political conflict by means of government largesse, particularly in industrial and social programs. However, populist dysfunction was also overrated. Both the US and UK retain their advantages in terms of innovation and dynamism, as revealed by the vaccine and its rollout (Chart 2). Chart 2Dysfunctional Anglo-Saxon Populism? No sharp leftward turn occurred in the UK, where Prime Minister Boris Johnson and his Conservatives had the benefit of a pre-COVID election in December 2019, which they won. By contrast, in the US, President Trump and the Republicans contended an election after the pandemic and recession had virtually doomed them to failure. There a sharp leftward turn is taking place. Going forward the US will reclaim the top rank in terms of fiscal stimulus, as Biden is likely to get his infrastructure plan (AJP) passed. Our updated US budget deficit projections appear in Chart 3. Our sister US Political Strategy gives the AJP an 80% chance of passing in some form and the AFP only a 50% chance of passing, depending on how quickly the AJP is passed. This means the blue dashed line is more likely to occur than the red dashed line. The difference is slight despite the mind-boggling headline numbers of the plans because the spending is spread out over eight-to-ten years and tax hikes over 15 years will partially offset the expenditures. Much will depend on whether Congress is willing to pay for the new spending. In Chart 3 we assume that Biden will get half of the proposed corporate tax hikes in the AJP scenario (and half of the individual tax hikes in the AFP scenario). If spending is watered down, and/or tax hikes surprise to the upside, both of which are possible, then the deficit scenarios will obviously tighten, assuming the economic recovery continues robustly as expected. But in the current political environment it is safest to plan for the most expansive budget deficit scenarios, as populism is the overriding force. Chart 3Biden’s Blowout Spending Biden’s campaign plan was even more visionary, so it is not true that Biden pulled a “bait and switch” on voters. Rather, the median voter is comfortable with greater deficits and a larger government role in American life. Bottom Line: The implication of Biden’s spending blowout is reflationary for the global economy, cyclically negative for the US dollar, and positive for global equities. But on a tactical time frame the rotation to other equities and currencies will also depend on China’s fiscal-and-credit deceleration and whether geopolitical risk continues to fall. Russia: Some Improvement But Coast Not Yet Clear US-Russia tensions appeared to fizzle over the past week but the coast is not yet clear. We remain short Russian currency and risk assets as well as European emerging market equities. Tensions fell after President Putin’s State of the Nation address on April 21 in which he warned the West against crossing Russia’s “red lines.” Biden’s sanctions on Russia were underwhelming – he did not insist on halting the final stages of the Nord Stream II pipeline to Germany. Russia declared it would withdraw its roughly 100,000 troops from the Ukrainian border by May 1. Russian dissident Alexei Navalny ended his hunger strike. Putin attended Biden’s Earth Day summit and the two are working on a bilateral summit in June. Chart 4Russia's Domestic Instability Will Continue De-escalation is not certain, however. First, some US officials have cast doubt on Russia’s withdrawal of troops and it is known that arms and equipment were left in place for a rapid mobilization and re-escalation if necessary. Second, Russian-backed Ukrainian separatists will be emboldened, which could increase fighting in Ukraine that could eventually provoke Russian intervention. Third, the US has until August or September to prevent Nord Stream from completion. Diplomacy between Russia and the US (and Russia and several eastern European states) has hit a low point on the withdrawal of ambassadors. Fourth, Russian domestic politics was always the chief reason to prepare for a worse geopolitical confrontation and it remains unsettled. Putin’s approval rating still lingers in the relatively low range of 65% and government approval at 49%. The economic recovery is weak and facing an increasingly negative fiscal thrust, along with Europe and China, Russia’s single-largest export destination (Chart 4). Putin’s handouts to households, in anticipation of the September Duma election, only amount to 0.2% of GDP. More measures will probably be announced but the lead-up to the election could still see an international adventure designed to distract the public from its socioeconomic woes. Russia’s geopolitical risk indicators ticked up as anticipated (Chart 5). They may subside if the military drawdown is confirmed and Biden and Putin lower the temperature. But we would not bet on it. Chart 5Russian Geopolitical Risk: Wait For 'All Clear' Signal Bottom Line: It is possible that Biden has passed his first foreign policy test with Russia but it is too soon to sound the “all clear.” We remain short Russian ruble and short EM Europe until de-escalation is confirmed. The Russian (and German) elections in September will mark a time for reassessing this view. Iran: Diplomacy On Track (Hence Jitters Will Rise) While Russia may or may not truly de-escalate tensions in Ukraine, the spring and summer are sure to see an increase in focus on US-Iran nuclear negotiations. Geopolitical risks will remain high prior to the conclusion of a deal and will materialize in kinetic attacks of various kinds. This thesis is confirmed by the alleged Israeli sabotage of Iran’s Natanz nuclear facility this month. The US Navy also fired warning shots at Iranian vessels staging provocations. Sporadic attacks in other parts of the region also continue to flare, most recently with an Iranian tanker getting hit by a drone at a Syrian oil terminal.2 The US and Iran are making progress in the Vienna talks toward rejoining the 2015 nuclear deal from which the US withdrew in 2018. Iran pledged to enrich uranium up to 60% but also said this move was reversible – like all its tentative violations of the Joint Comprehensive Plan of Action (JCPA) so far (Table 1). Iran also offered a prisoner swap with the US. Saudi Arabia appears resigned to a resumption of the JCPA that it cannot prevent, with crown prince Mohammed bin Salman offering diplomatic overtures to both the US and Iran. Table 1Iran’s Nuclear Program And Compliance With JCPA 2015 Still, the closer the US and Iran get to a deal the more its opponents will need to either take action or make preparations for the aftermath. The allegation that former US Secretary of State John Kerry’s shared Israeli military plans with Iranian Foreign Minister Javad Zarif is an example of the kind of political brouhaha that will occur as different elements try to support and oppose the normalization of US-Iran ties. More importantly Israel will underscore its red line against nuclear weaponization. Previously Iran was set to reach “breakout” capability of uranium enrichment – a point at which it has enough fissile material to produce a nuclear device – as early as May. Due to sabotage at the Natanz facility the breakout period may have been pushed back to July.3 This compounds the significance of this summer as a deadline for negotiating a reduction in tensions. While the US may be prepared to fudge on Iran’s breakout capabilities, Israel will not, which means a market-relevant showdown should occur this summer before Israel backs down for fear of alienating the United States. Tit-for-tat attacks in May and June could cause negative surprises for oil supply. Then there will be a mad dash by the negotiators to agree to deal before the de facto August deadline, when Iran inaugurates a new president and it becomes much harder to resolve outstanding issues. Chart 6Iran Deal Priced Into Oil Markets? Hence our argument that geopolitics adds upside risk to oil prices in the first half of the year but downside risk in the second half. The market’s expectations seem already to account for this, based on the forward curve for Brent crude oil. The marginal impact of a reconstituted Iran nuclear deal on oil prices is slightly negative over the long run since a deal is more likely to be concluded than not and will open up Iran’s economy and oil exports to the world. However, our Commodity & Energy Strategy expects the Brent price to exceed expectations in the coming years, judging by supply and demand balances and global macro fundamentals (Chart 6). If an Iran deal becomes a fait accompli in July and August the Saudis could abandon their commitment to OPEC 2.0’s production discipline. The Russians and Saudis are not eager to return to a market share war after what happened in March 2020 but we cannot rule it out in the face of Iranian production. Thus we expect oil to be volatile. Oil producers also face the threat of green energy and US shale production which gives them more than one reason to keep up production and prevent prices from getting too lofty. Throughout the post-2015 geopolitical saga between the US and Iran, major incidents have caused an increase in the oil-to-gold ratio. The risk of oil supply disruption affected the price more than the flight to gold due to geopolitical or war risk. The trend generally corresponds with that of the copper-to-gold ratio, though copper-to-gold rose higher when growth boomed and oil outperformed when US-Iran tensions spiked in 2019. Today the copper-to-gold ratio is vastly outperforming the oil-to-gold on the back of the global recovery (Chart 7). This makes sense from the point of view of the likelihood of a US-Iran deal this year. But tensions prior to a deal will push up oil-to-gold in the near term. Chart 7Biden Passes Iran Test? Likely But Not A Done Deal Bottom Line: The US-Iran diplomacy is on track. This means geopolitical risk will escalate in May and June before a short-term or interim deal is agreed in July or August. Geopolitical risk stemming from US-Iran relations will subside thereafter, unless the deadline is missed. The forward curve has largely priced in the oil price downside except for the risk that OPEC 2.0 becomes dysfunctional again. We expect upside price surprises in the near term. Biden, China, And Our Australia GeoRisk Indicator Ostensibly the US and Russia are avoiding a war over Ukraine and the US and Iran are negotiating a return to the 2015 nuclear deal. Only US-China relations utterly lack clarity, with military maneuvering in the Taiwan Strait and South China Sea and tensions simmering over the gamut of other disputes. Chart 8Biden Still Faces China Test The latest data on global military spending show not only that the US and China continue to build up their militaries but also that all of the regional allies – including Japan! – are bulking up defense spending (Chart 8). This is a substantial confirmation of the secular growth of geopolitical risk, specifically in reaction to China’s rise and US-China competition. The first round of US-China talks under Biden went awry but since then a basis has been laid for cooperation on climate change, with President Xi Jinping attending Biden’s virtual climate change summit (albeit with no bilateral summit between the two). If John Kerry is removed as climate czar over his Iranian controversy it will not have an impact other than to undermine American negotiators’ reliability. The deeper point is that climate is a narrow basis for US-China cooperation and it cannot remotely salvage the relationship if a broader strategic de-escalation is not agreed. Carbon emissions are more likely to become a cudgel with which the US and West pressure China to reform its economy faster. The Department of Defense is not slated to finish its comprehensive review of China policy until June but most US government departments are undertaking their own reviews and some of the conclusions will trickle out in May, whether through Washington’s actions or leaks to the press. Beijing could also take actions that upend the Biden administration’s assessment, such as with the Microsoft hack exposed earlier this year. The Biden administration will soon reveal more about how it intends to handle export controls and sanctions on China. For example, by May 19 the administration is slated to release a licensing process for companies concerned about US export controls on tech trade with China due to the Commerce Department’s interim rule on info tech supply chains. The Biden administration looks to be generally hawkish on China, a view that is now consensus. Any loosening of punitive measures would be a positive surprise for Chinese stocks and financial markets in general. There are other indications that China’s relationship with the West is not about to improve substantially – namely Australia. Australia has become a bellwether of China’s relations with the world. While the US’s defense commitments might be questionable with regard to some of China’s neighbors – namely Taiwan (Province of China) but also possibly South Korea and the Philippines – there can be little doubt that Australia, like Japan, is the US’s red line in the Pacific. Australian politics have been roiled over the past several years by the revelation of Chinese influence operations, state- or military-linked investments in Australia, and propaganda campaigns. A trade war erupted last year when Australia called for an investigation into the origins of COVID-19 and China’s handling of it. Most recently, Victoria state severed ties with China’s Belt and Road Initiative. Despite the rise in Sino-Australian tensions, the economic relationship remains intact. China’s stimulus overweighed the impact of its punitive trade measures against Australia, both by bidding up commodity prices and keeping the bulk of Australia’s exports flowing (Chart 9). As much as China might wish to decouple from Australia, it cannot do so as long as it needs to maintain minimum growth rates for the sake of social stability and these growth rates require resources that Australia provides. For example, global iron ore production excluding Australia only makes up 80% of China’s total iron ore imports, which necessitates an ongoing dependency here (Chart 10). Brazil cannot make up the difference. Chart 9China-Australia Trade Amid Tensions Chart 10China Cannot Replace Australia This resource dependency does not necessarily reduce geopolitical tension, however, because it increases China’s supply insecurity and vulnerability to the US alliance. The US under Biden explicitly aims to restore its alliances and confront autocratic regimes. This puts Australia at the front lines of an open-ended global conflict. Chart 11Introducing: Australia GeoRisk Indicator (Smoothed) Our newly devised Australia GeoRisk Indicator illustrates the point well, as it has continued surging since the trade war with China first broke out last year (Chart 11). This indicator is based on the Australian dollar and its deviation from underlying macro variables that should determine its course. These variables are described in Appendix 1. If the Aussie weakens relative to these variables, then an Australian-specific risk premium is apparent. We ascribe that premium to politics and geopolitics writ large. A close examination of the risk indicator’s performance shows that it tracks well with Australia’s recent political history (Chart 12). Previous peaks in risk occurred when President Trump rose to power and Australia, like Canada, found itself beset by negative pressures from both the US and China. In particular, Trump threatened tariffs and the Australian government banned China’s Huawei from its 5G network. Today the rise in geopolitical risk stems almost exclusively from China. There is potential for it to roll over if Biden negotiates a reduction in tensions but that is a risk to our view (an upside risk for Australian and global equities). Chart 12Australian GeoRisk Indicator (Unsmoothed) What does this indicator portend for tradable Australian assets? As one would expect, Australian geopolitical risk moves inversely to the country’s equities, currency, and relative equity performance (Chart 13). Australian equities have risen on the back of global growth and the commodity boom despite the rise in geopolitical risk. But any further spike in risk could jeopardize this uptrend. Chart 13Australia Geopolitical Risk And Tradable Assets An even clearer inverse relationship emerges with the AUD-JPY exchange rate, a standard measure of risk-on / risk-off sentiment in itself. If geopolitical risk rises any further it should cause a reversal in the currency pair. Finally, Australian equities have not outperformed other developed markets excluding the US, which may be due to this elevated risk premium. Bottom Line: China is the most important of Biden’s foreign policy hurdles and unlike Russia and Iran there is no sign of a reduction in tension yet. Our Australian GeoRisk Indicator supports the point that risk remains very elevated in the near term. Moreover China’s credit deceleration is also negative for Australia. Cyclically, however, assuming that China does not overtighten policy, we take a constructive view on the Aussie and Australian equities. Biden’s Border Troubles Distract From Bullish Mexico Story The biggest criticism of Biden’s first 100 days has been his reduction in a range of enforcement measures on the southern border which has encouraged an overflow of immigrants. Customs and Border Patrol have seen a spike in “encounters” from a low point of around 17,000 in 2020 to about 170,000 today. The trend started last year but accelerated sharply after the election and had surpassed the 2019 peak of 144,000. Vice President Kamala Harris has been put in charge of managing the border crisis, both with Mexico and Central American states. She does not have much experience with foreign policy so this is her opportunity to learn on the job. She will not be able to accomplish much given that the Biden administration is unwilling to use punitive measures or deterrence and will not have large fiscal resources available for subsidizing the nations to the south. With the US economy hyper-charged, especially relative to its southern neighbors, the pace of immigration is unlikely to slacken. From a macro point of view the relevance is that the US is not substantially curtailing immigration – quite the opposite – which means that labor force growth will not deviate from its trend. What about Mexico itself? It is not likely that Harris will be able to engage on a broader range of issues with Mexico beyond immigration. As usual Mexico is beset with corruption, lawlessness, and instability. To these can be added the difficulties of the pandemic and vaccine rollout. Tourism and remittances are yet to recover. Cooperation with US federal agents against the drug cartels is deteriorating. Cartels control an estimated 40% of Mexican territory.4 Nevertheless, despite Mexico’s perennial problems, we hold a positive view on Mexican currency and risk assets. The argument rests on five points: Strong macro fundamentals: With China’s fiscal-and-credit impulse slowing sharply, and US stimulus accelerating, Mexico stands to benefit. Mexico has also run orthodox monetary and fiscal policies. It has a demographic tailwind, low wages, and low public debt. The stars are beginning to align for the country’s economy, according to our Emerging Markets Strategy. US and Canadian stimulus: The US and Canada have the second- and third-largest fiscal stimulus of all the major countries over the 2019-21 period, at 9% and 8% of GDP respectively. Mexico, with the new USMCA free trade deal in hand, will benefit. US protectionism fizzled: Even Republican senators blocked President Trump’s attempted tariffs on Mexico. Trump’s aggression resulted in the USMCA, a revised NAFTA, which both US political parties endorsed. Mexico is inured to US protectionism, at least for the short and medium term. Diversification from China: Mexico suffered the greatest opportunity cost from China’s rise as an offshore manufacturer and entrance to the World Trade Organization. Now that the US and other western countries are diversifying away from China, amid geopolitical tensions, Mexico stands to benefit. The US cannot eliminate its trade deficit due to its internal savings/investment imbalance but it can redistribute that trade deficit to countries that cannot compete with it for global hegemony. AMLO faces constraints: A risk factor stemmed from politics where a sweeping left-wing victory in 2018 threatened to introduce anti-market policies. President Andrés Manuel López Obrador (known as AMLO) and his MORENA party gained a majority in both houses of the legislature. Their coalition has a two-thirds majority in the lower house (Chart 14). However, we pointed out that AMLO’s policies have not been radical and, more importantly, that the midterm election would likely constrain his power. Chart 14Mexico’s Midterm Election Looms These are all solid points but the last item faces a test in the upcoming midterm election. AMLO’s approval rating is strong, at 63%, putting him above all of his predecessors except one (Chart 15). AMLO’s approval has if anything benefited from the COVID-19 crisis despite Mexico’s inability to handle the medical challenge. He has promised to hold a referendum on his leadership in early 2022, more than halfway through his six-year term, and he is currently in good shape for that referendum. For now his popularity is helpful for his party, although he is not on the ballot in 2021 and MORENA’s support is well beneath his own. Chart 15AMLO’s Approval Fairly Strong MORENA’s support is holding at a 44% rate of popular support and its momentum has slightly improved since the pandemic began. However, MORENA’s lead over other parties is not nearly as strong as it was back in 2018 (Chart 16, top panel). The combined support of the two dominant center-right parties, the Institutional Revolutionary Party and the National Action Party, is almost equal to that of MORENA. And the two center-left parties, the Democratic Revolution Party and Citizen’s Movement, are part of the opposition coalition (Chart 16, bottom panel). The pandemic and economic crisis will motivate the opposition. Chart 16MORENA’s Support Holding Up Despite COVID Traditionally the president’s party loses seats in the midterm election (Table 2). Circumstances are different from the US, which also exhibits this trend, because Mexico has more political parties. A loss of seats from MORENA does not necessarily favor the establishment parties. Nevertheless opinion polling shows that about 45% of voters say they would rather see MORENA’s power “checked” compared to 41% who wish to see the party go on unopposed.5 Table 2Mexican President’s Party Tends To Lose Seats In Midterm Election While the ruling coalition may lose its super-majority, it is not a foregone conclusion that MORENA will lose its majority. Voters have decades of experience of the two dominant parties, both were discredited prior to 2018, and neither has recovered its reputation so quickly. The polling does not suggest that voters regret their decision to give the left wing a try. If anything recent polls slightly push against this idea. If MORENA surprises to the upside then AMLO’s capabilities would increase substantially in the second half of his term – he would have political capital and an improving economy. While the senate is not up for grabs in the midterm, MORENA has a narrow majority and controls a substantial 60% of seats when its allies are taken into account. In this scenario AMLO could pursue his attempts to increase the state’s role in key industries, like energy and power generation, at the expense of private investors. Even then the Supreme Court would continue to act as a check on the government. The 11-seat court is currently made up of five conservatives, two independents, and three liberal or left-leaning judges. A new member, Margarita Ríos Farjat, is close to the government, leaving the conservatives with a one-seat edge over the liberals and putting the two independents in the position of swing voters. Even if AMLO maintains control of the lower house, he will not be able to override the constitutional court, as he has threatened on occasion to do, without a super-majority in the senate. Bottom Line: AMLO will likely lose some ground in the lower house and thus suffer a check on his power. This will only confirm that Mexican political risk is not likely to derail positive underlying macro fundamentals. Continue to overweight Mexican equities relative to Brazilian.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix 1 The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our Australian GeoRisk Indicator (see Chart 11-12 above) uses the same simple methodology used in our other indicators, which avoid the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the AUD, and compare its movement against several fundamental factors – in this case global energy and base metal prices, global metals and mining stock prices, and the Chilean peso. Australia is a commodity-exporting country. It is the largest producer of iron ore and is among the largest producers of coal and natural gas. It is also a major trading partner for China. Due to the nature of its economy the Australian dollar moves with global metal and energy prices and the global metals and mining equity prices. Chile, another major commodity producer also moves with global metal prices, hence our inclusion of the peso in this indicator. The AUD has a high correlation with all of these assets, and if the changes in the value of the AUD lag or lead the changes in the value of these assets, the implication is that geopolitical risk unique to Australia is not priced by the market. We included the peso as Chile is not as affected as Australia by any conflict in the South China Sea or Northeast Asia, which means that a deviation of the AUD from CLP represents a unique East Asia Pacific risk. Our indicator captures the involvement of Australia in a few regional and international conflicts. The indicator climbed as Australia got involved in the East Timor emergency and declined as it exited. It continued declining even as Australia joined the US in the Afghanistan and Iraq wars, which showed that investors were unperturbed by faraway wars, while showing measurable concern in the smaller but closer Timorese conflict. Risks went up again as the nation erupted in labor protests as the Howard government made changes to the labor code. We see the market pricing higher risk again during the 2008 financial crisis, although it was modest and Australia escaped the crisis unscathed due to massive Chinese stimulus. Since then, investors have been climbing a wall of worry as they priced in Northeast Asia-related geopolitical risks. These started with the South Korean Cheonan sinking and continued with the Sino-Japanese clash over the Senkaku islands. They culminated with the Chinese ADIZ declaration in late 2013. In 2016, Australia was shocked again when Donald Trump was elected, and investor fears were evident when the details of Trump-Turnbull spat were made public. The risk indicator reached another peak during the trade wars between the US and the rest of the world. Investors were not worried about COVID-19 as Australia largely contained the pandemic, but the recent Australian-Chinese trade war pushed the risk indicator up, giving investors another wall of worry. If the Biden administration forces Australia into a democratic alliance in confrontation with autocratic China then this risk will persist for some time.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com We Read (And Liked) ... The Narrow Corridor: States, Societies, And The Fate Of Liberty This book is a sweeping review of the conditions of liberty essential to steering the world away from the Hobbesian war of all against all. In this unofficial sequel to the 2012 hit, Why Nations Fail: The Origins Of Power, Prosperity, And Poverty, Daron Acemoglu (Professor of Economics at the Massachusetts Institute of Technology) and James A. Robinson (Professor of Global Conflict Studies at the University of Chicago) further explore their thesis that the existence and effectiveness of democratic institutions account for a nation’s general success or failure. The Narrow Corridor6 examines how liberty works. It is not “natural,” not widespread, “is rare in history and is rare today.” Only in peculiar circumstances have states managed to produce free societies. States have to walk a thin line to achieve liberty, passing through what the authors describe as a “narrow corridor.” To encourage freedom, states must be strong enough to enforce laws and provide public services yet also restrained in their actions and checked by a well-organized civil society. For example, from classical history, the Athenian constitutional reforms of Cleisthenes “were helpful for strengthening the political power of Athenian citizens while also battling the cage of norms.” That cage of norms is the informal body of customs replaced by state institutions. Those norms in turn “constrained what the state could do and how far state building could go,” providing a set of checks. Though somewhat fluid in its definition, liberty, as Acemoglu and Robinson show, is expressed differently under various “leviathans,” or states. For starters, the “Shackled Leviathan” is a government dedicated to upholding the rule of law, protecting the weak against the strong, and creating the conditions for broad-based economic opportunity. Meanwhile, the “Paper Leviathan” is a bureaucratic machine favoring the privileged class, serving as both a political and economic brake on development and yielding “fear, violence, and dominance for most of its citizens.” Other examples include: The “American Leviathan” which fails to deal properly with inequality and racial oppression, two enemies of liberty; and a “Despotic Leviathan,” which commands the economy and coerces political conformity – an example from modern China. Although the book indulges in too much jargon, it is provocative and its argument is convincing. The authors say that in most places and at most times, the strong have dominated the weak and human freedom has been quashed by force or by customs and norms. Either states have been too weak to protect individuals from these threats or states have been too strong for people to protect themselves from despotism. Importantly, many states believe that once liberty is achieved, it will remain the status quo. But the authors argue that to uphold liberty, state institutions have to evolve continuously as the nature of conflicts and needs of society change. Thus society's ability to keep state and rulers accountable must intensify in tandem with the capabilities of the state. This struggle between state and society becomes self-reinforcing, inducing both to develop a richer array of capacities just to keep moving forward along the corridor. Yet this struggle also underscores the fragile nature of liberty. It is built on a precarious balance between state and society; between economic, political, and social elites and common citizens; between institutions and norms. If one side of the balance gets too strong, as has often happened in history, liberty begins to wane. The authors central thesis is that the long-run success of states depends on the balance of power between state and society. If states are too strong, you end up with a “Despotic Leviathan” that is good for short-term economic growth but brittle and unstable over the long term. If society is too strong, the “Leviathan” is absent, and societies suffer under a pre-modern war of all against all. The ideal place to be is in the narrow corridor, under a shackled Leviathan that will grow state capacity and individual liberty simultaneously, thus leading to long-term economic growth. In the asset allocation process, investors should always consider the liberty of a state and its people, if a state’s institutions grossly favor the elite or the outright population, whether these institutions are weak or overbearing on society, and whether they signify a balance between interests across the population. Whether you are investing over a short or long horizon, returns can be significantly impacted in the absence of liberty or the excesses of liberty. There should be a preference among investors toward countries that exhibit a balance of power between state and society, setting up a better long-term investment environment, than if a balance of power did not exist.   Guy Russell Research Analyst GuyR@bcaresearch.com GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Footnotes 1 "President Biden’s first 100 days as president fact-checked," BBC News, April 29, 2021, bbc.com. 2 "Oil tanker off Syrian coast hit in suspected drone attack," Al Jazeera, April 24, 2021, Aljazeera.com. 3 See Yaakov Lappin, "Natanz blast ‘likely took 5,000 centrifuges offline," Jewish News Syndicate, jns.org. 4 John Daniel Davidson, "Former US Ambassador To Mexico: Cartels Control Up To 40 Percent Of Mexican Territory," The Federalist, April 28, 2021, thefederalist.com. 5 See Alejandro Moreno, "Aprobación de AMLO se encuentra en 61% previo a campañas electorales," El Financiero, April 5, 2021, elfinanciero.com. 6 Penguin Press, New York, NY, 2019, 558 pages. Section III: Geopolitical Calendar

Special Report

Highlights The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. Feature In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,1 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP2 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.3 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,1 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.4 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 2 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 3 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 4 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Special Report

Highlights Cryptocurrencies have a long march ahead to be able to displace fiat currencies. While cryptocurrencies are improving tremendously as a medium of exchange, they lag fiat as a store of value and a unit of account. Contrary to popular belief, fiat money has outperformed anti-fiat assets over time as a store of value. Many central banks will replicate the advantages and success of bitcoin through the issuance of central bank digital currencies (CBDCs). Cryptocurrencies are unlikely to disappear anytime soon and can be wonderful speculative investments. However, conservative investors should stick with gold and silver. Feature Chart I-1Spectacular Returns From Cryptocurrencies The rise in the prices of various cryptocurrencies1 has taken many investors by surprise. $1000 invested in bitcoin at the start of 2012 is worth around $10 million today. If you were lucky enough to get in on the first day of trading, when it was worth a fraction of a cent, your initial $1000 investment will be worth around $60 billion today. Meanwhile, many other cryptocurrencies are also sporting legendary returns, not even replicable in the most obscure corners of the options market (Chart I-1). There is some merit to cryptocurrencies, or more specifically, blockchain technology that is the bedrock of their invention. In this decentralized, peer-to-peer system, the need for an intermediary to validate transactions and arbitrate disputes is eliminated. This can greatly reduce transaction costs, especially when compared to banking/legal fees. The autonomy and anonymity that comes with their use is also a desirable feature. For example, anti-fiat enthusiasts welcome the fact that the creation, distribution, and use of cryptocurrencies is outside the purview of central banks. As this asset class continues to garner popularity and capture the imagination of investors, the implications run the gamut from potential future returns (or losses) to the impact on other asset classes. For currency investors, the key question is whether any of these seemingly attractive features have a sizeable impact on the value and use of other developed market currencies. In short, will cryptocurrencies displace fiat? To answer this question, we have to start from the very basic definition of what money is.  Is Bitcoin Money? The three basic functions of money are a store of value, unit of account and a medium of exchange. On at least two of these three basic functions, bitcoin fails. Bitcoin has been improving as a medium of exchange. The ability to swap fiat currency into bitcoins and back is fairly easy. More importantly, more and more merchants are accepting bitcoin as a form of payment. Globally, the turnover of cryptocurrencies is about $200 billion or roughly 3% of overall foreign exchange turnover. This is higher than daily trading in the Mexican peso, the New Zealand dollar, and the Swedish krona, an impressive feat (Chart I-2). This is also evidenced by the rise in the market capitalization of cryptocurrencies, to around $2 trillion today (Chart I-3). Chart I-2An Improving Medium Of Exchange Chart I-3Gold Versus Cryptocurrencies However, as Peter Berezin, our Chief Global Strategist has pointed out, this does not necessarily trump the use of fiat money.2  The Visa network, for example, handles over 5,000 times more transactions a second than the bitcoin mempool (the pool of unconfirmed transactions). Meanwhile, if one were to take a vacation in exotic places like Manila or Mumbai, what medium of exchange will one hold? Cryptocurrency, gold or the US dollar? Experience tells us you will be much better off holding greenbacks or even gold. Bitcoin is certainly not a store of value. The drawdown in cryptocurrency prices has been around 80% a year or 40%-50% over three months. This is much more volatile than currencies such as the Turkish lira or Argentinian peso, from countries fraught with political instability and economic fragility (Chart I-4). It appears that the lack of central bank oversight is a vice and not a virtue. Stability in a currency allows for confidence in savings, future purchases, and investment decisions. A monetary system based on cryptocurrencies deprives citizens of this basic tenet.   Chart I-4Bitcoin Is A Poor Store Of Value Bitcoin’s inherent volatility also makes it unsuitable as a unit of account. Prices quoted in bitcoin units will need to be revised daily. Although not a parallel comparison, this is reminiscent of hyperinflationary Zimbabwe, where retail store prices were adjusted several times a day to reflect the rapid depreciation in the currency. This is hardly a monetary regime suitable for the developed world, or any other economy for that matter. In a nutshell, cryptocurrencies do not yet satisfy the basic functions of money. Yes, they are portable, divisible, fungible and in limited supply. However, they have yet to gain wider acceptance, and are not a store of value nor a unit of account. As such, they remain speculative investments rather than money. The Demise Of Fiat Is Exaggerated Even if bitcoin is not money, the question remains whether it should be held in currency portfolios as insurance against fiat money debasement. After all, central bank quantitative easing since the global financial crisis has benefited other monetary assets such as gold and silver. Should investors also accumulate cryptocurrencies? The answer will depend on the type of investor. Dedicated currency investors need not worry about bitcoin. As a starting point, the US dollar very much remains the reserve currency today. About 60% of global reserve allocation is in USD. This position has often been challenged over the last few decades but has never been threatened (Chart I-5). This puts cryptocurrencies a long way from the starting line. Chart I-5The US Dollar Remains King It is worth noting that over time, fiat assets have done much better than anti-fiat alternatives. Using Bank of England data from the 19th century, we can see that over time, government bonds did much better than gold, or even stocks and real estate (Chart I-6). The reason is that most currencies provide a yield, while cryptocurrencies and gold do not. Chart I-6Fiat Versus Anti-Fiat Assets Chart I-7The DXY Has Faced Strong Resistance At 100 If one is worried about the path of the US dollar (like us), there are many other established fiat currencies to choose from. Since 2015, global allocation of FX Reserves to US dollars has fallen from almost 66% to around 60% today. The rotation has favored other currencies such as the Japanese yen, Chinese yuan and even gold (Chart I-7). From a longer-term perspective, this will place a durable floor under developed market currencies. Cryptocurrencies Versus Gold The degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Central banks have a natural imperative to defend fiat currencies, since these are the very tools they use to implement monetary policy. As such, when diversifying out of dollars, their choice is other fiat currencies or gold, the latter having been a monetary standard for centuries. Private investors, some wanting to cut the cord to a centralized monetary system, may chose cryptocurrencies. Since the peak in the DXY index in 2020, both gold and US Treasuries are down significantly, while bitcoin has catapulted to new highs (Chart I-8). This has occurred because of a change in leadership, where the biggest sellers of US Treasuries have not been official concerns, but private investors (Chart I-9). Foreign central banks still dominate the holding of US Treasuries, to the tune of 60% versus 40% for private investors (bottom panel). But the bulk of outflows has been coming from private investors. Chart I-8Bitcoin Thrives When Mainstream Havens Are Rolling Over Chart I-9A Treasury Liquidation From ##br##Private Investors Central banks (the biggest holders of US Treasuries) tend to have stronger hands. This is because central banks are ideological while private investors can be swayed by momentum. For example, China and Russia have a geopolitical imperative to diversify out of dollars. As a result, Russia now has almost 25% of its foreign exchange reserves in gold and China almost 4%. A conservative investor looking to diversify out of fiat currency should naturally choose gold, which is backed by strong buyers. For more speculative investors, a simple rule of thumb could work: Buy cryptocurrencies when they drop 50% and sell when they overtake their previous highs. As we showed in Chart I-3, cryptocurrencies drop at least 40%-50% every year or so, providing ample opportunity to accumulate long positions. It is worth noting that my colleagues have a different approach. Dhaval Joshi, who heads our Counterpoint product, suggests holding cryptocurrencies in inverse proportion to their relative volatility to gold. In other words, given that bitcoin is three times more volatile than gold, your anti-fiat portfolio should have a 25% allocation to cryptocurrencies.3 Peter Berezin, our Chief Global Strategist, will not touch bitcoin. We tend to agree that cryptocurrencies could be a playable mania but would not recommend this asset class for the longer term. Central Bank Digital Currencies   One argument for why cryptocurrencies may not survive over the longer term is that there is a natural limit to how much widespread acceptance they will achieve before central banks start clamping down on them. The first reason will be due to the loss in seigniorage revenue for central banks. Between 2009 and 2019, the US and China generated about $140bn a year in seigniorage revenue (Chart I-10). These are non-negligible sums, which the rapid proliferation of cryptocurrencies threaten. Moreover, as the turnover in cryptocurrencies overtakes global trading in various domestic currencies, many countries are moving to ban bitcoin transactions (Table I-1). Chart I-10Seigniorage Revenue Is Significant Table 1A Rising List Of Cryptocurrency Bans Second, the use of cryptocurrencies can encourage the proliferation of illegal activities. This is a well-known flaw, and something governments will push back against. Meanwhile, many central banks are moving to establish their own digital currencies. Some of these could be based off the same blockchain technology that underpins bitcoin. This will provide many of the advantages of using a cryptocurrency without some of the known pitfalls. Map I-1 highlights that most G10 central banks have a digital currency plan. Map I-1Many Central Banks Are Planning A Digital Currency Some advocates for bitcoin point to its limited supply (21 million coins) as evidence for monetary prudence. Even the gold standard had more flexibility, since gold mining expanded about 2% a year. Yet that still proved to be extremely deflationary. A monetary standard that includes both paper currency and CBDCs provides the flexibility that central bankers need to smooth out economic cycles. A bitcoin-based standard will take us back to the middle ages. Once CDBCs become mainstream, the need for alternative cryptocurrencies will not disappear but fall greatly. This will also happen as the number of cryptocurrencies being created will likely balloon, given the very impressive price rallies in recent years. The IPO of Coinbase, an exchange for trading cryptocurrencies, may have heralded the peak in sentiment. Investment Conclusions The dollar faces many headwinds over the next 12 months. A rebound in global growth that begins to favor non-US economies will benefit pro-cyclical currencies. The Federal Reserve’s liquidity injections have assuaged the dollar shortage that held markets hostage last year. Interest rates are now moving against the dollar. Meanwhile, the greenback is expensive (Chart I-11), with a negative balance of payments backdrop. Chart I-11The US Dollar Is Expensive Chart I-12Hold Precious Metals Our favorite vehicles to play against coming weakness in the dollar have been the Scandinavian currencies, precious metals and commodity currencies. Within the precious metals sphere, we like both gold and silver but are short the gold/silver ratio as a hedged trade with little downside and much upside (Chart I-12). In particular, precious metals benefit from reserve diversification out of US dollars. In this light, cryptocurrencies could have intermittent rallies. However, given the regulatory and structural issues they face, we will not be holders for the long term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 We use bitcoin and cryptocurrencies interchangeably in this text. We do acknowledge that there are various other cryptocurrencies and these are shown in Chart 1. 2 Please see Global Investment Strategy Special Report, "Bitcoin: A Solution In Search Of A Problem," dated February 26, 2021. 3 Please see Counterpoint Strategy Special Report, "Why Cryptocurrencies Are Here To Stay And Bitcoin Is Worth $120,000," dated April 8, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 March housing starts came in at 1.7 million, versus expectations of 1.6 million. This was a 19.4% month-on-month rise. Building permits were equally strong at 1.8 million for the month of March. The University of Michigan sentiment indicator rose to 86.5 in April from 84.9. The jump in the current conditions component from 93 to 97.2 was noteworthy. Initial jobless claims continue to decline, coming in at 547K for the week of April 17. Existing home sales remained strong at 6 million, even though they fell 3.7% month-on-month. The DXY Index fell by 0.3% this week. Speculators pared back a bit of their bullish positioning on the dollar. The overhang of a risk-off event continues to anchor dollar bulls, but interest rate differentials are now moving against the greenback. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent euro area data have been mixed. The trade balance came in at €18.4 billion in February, versus €24.2 billion the previous month. This supported a current account balance of €25.9 billion. Construction output fell 5.8% year-on-year in February. Consumer confidence came in at -8.1 in April, versus -10.8 in March. The euro rose by 0.3% this week. The ECB kept monetary policy on hold this week, leaving the deposit facility rate at -0.5% and the marginal lending facility at 0.25%. This garnered little market reaction. With a few euro area countries under lockdown, this was the correct stance. Covid-19 will continue to dictate the near-term path of policy and the euro, but we remain bullish longer term. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been robust. Exports surged 16.1% year-on-year in March. Imports were also robust at +5.7% year-on-year. This boosted the trade balance to ¥298 billion. Tokyo condominiums for sale are rising 45% year-on-year. Supermarket sales rose 1.3% year-on-year in March. This is a tentative but positive sign of a consumption recovery. The Japanese yen rose 0.6% this week. The yen has been the best performing currency this week, a sign that sentiment was overly bearish and the currency was much oversold. Our intermediate-term indicator remains at bombed-out levels and speculators are still short the yen. This provides further upside for this defensive currency. As a portfolio hedge, we are short EUR/JPY. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was an avalanche of positive data from the UK this week. Rightmove house prices came in at 5.1% year on year in April. The labor report was mixed. While the UK lost 73 thousand jobs in February, this was below expectations of a 145 thousand loss. Core CPI came in at 1.1% in March. The RPI index came in at 1.5% year-on-year, in line with expectations. The CBI business optimism survey came in at 38 in April, versus -22 the previous month. Cable rose by 0.4% this week. The UK economy continues to benefit from its strong vaccination campaign. With the prospect of the rest of the world catching up, this trade is now long in the tooth. In short, we are neutral the pound in the short term, but remain bullish longer-term. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There was scant data out of Australia this week. The NAB business confidence index came in at 17 in Q1 versus 14 the prior quarter. The Australian dollar fell by 0.6% against the US dollar this week. The Aussie came out of the Covid-19 crisis as one of the best performing currencies, so some measure of consolidation is to be expected. Our intermediate-term indicator continues to blast downward, while sentiment towards the Aussie remains quite elevated. However, we believe that this will be a healthy consolidation in what could prove to be a multi-year bull market in the Australian dollar. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week. CPI came in at 1.5% in Q1, in line with expectations. The Kiwi fell by 0.2% against the US dollar this week. Like Australia, New Zealand has managed the Covid-19 crisis quite well and the new travel bubble between the two countries will help lift economic activity. From a technical perspective however, room for further consolidation in the Kiwi remains. Our intermediate-term indicator continues to drift lower, while speculators are slightly long the cross. In our models, the Kiwi also appears overvalued. We were long AUD/NZD but were stopped out this week for modest profits. We will look to reestablish the trade. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada has been quite strong. Foreigners continue to flock into Canadian capital markets, to the tune of C$8.5bn in February. Housing starts came in at 335 thousand in March, the highest since the 70s. The Teranet house price index rose 10.8% year-on-year in March. The CPI release for March was better than expected. Headline was at 2.2%, the core median was at 2.1% and the trimmed mean came in at 2.2%. The Canadian dollar rose by 0.3% this week. The Bank of Canada kept rates on hold, but trimmed asset purchases. This follows a very generous budget from the Liberal party earlier this week. The loonie loved the news and Canadian government bonds sold off. We remain bullish CAD/USD on valuation grounds, spillovers from US fiscal stimulus and a constructive oil backdrop.  Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent data out of Switzerland has been quite strong. Producer and import prices fell by 0.2% year-on-year in March. This is a tremendous improvement from the previous 1.1% drop. M3 money supply continues to expand at a robust 5.6% clip. Exports rose 4.5% month-on-month in March. Watch exports surged 37% year-on-year. The Swiss franc rose 0.5% this week. The Swiss franc is the second best performing currency this week after the yen. With US interest rates stabilizing, the rationale for CHF carry trades is slowly fading. Our intermediate-term indicator shows the franc at bombed-out levels, and speculators are still short. This provides some margin for further upside. We are long EUR/CHF, but with very tight stops. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week. Industrial confidence came in at 8.2 in Q1, versus a prior reading of 3.1. The Norwegian krone was flat against the US dollar this week. Norway is setting the tone in terms of what monetary policy and sovereign wealth management could look like for many countries in the coming years. First, the Norges Bank announced they would be testing digital currency solutions over the coming two years. This is the way forward for central banks. Second, the sovereign wealth fund, the biggest in the world, is using its influence to effect policy changes towards the environment. Should the returns from its investments pay off in the years ahead, this could generate powerful repatriation flows for Norway. We are strategically bullish the NOK. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There was no data out of Sweden this week. The Swedish krona rose by 0.2% this week. Swedish 2-year real rates recently punched above US levels, suggesting downward pressure on the krona should soon be abating. Our intermediate-term indicator suggests weakness in the krona is mostly done, while the currency appears cheap in most of our models. The handicap for Sweden is successfully dealing with the pandemic, after having a model that stood apart from what other countries were following. Over the longer-term, we are bullish SEK, just like the NOK, against both the euro and the dollar. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Investors’ hunt for yield over the past few years led them to view leveraged loans as an attractive investment. Characterized by low volatility and attractive risk-adjusted returns, leveraged loans can add value to a portfolio. Leveraged loans tend to outperform their fixed-rate counterparts (for example, high-yield bonds) in an environment of rising rates and an attractive valuation starting point. Only the former criterion is true currently. Risks do exist, however. The increasing share of covenant-lite issues, and rising leverage in the corporate sector are of particular concern. Over the next 6-to-12 months, we do not expect rates to rise substantially, making the asset class somewhat unappealing in the short term. The longer-term outlook is attractive nevertheless, since rates are likely to rise as inflation picks up over the coming years. Feature In today’s environment of ultra-accommodative monetary policy, including low interest rates, and unattractive valuations for fixed-income risk assets, investors have no option but to look beyond conventional fixed-income instruments and dial up their risk appetite. In this Special Report, we run through the mechanics of the leveraged loan market. We analyze historical risk-return characteristics and compare leveraged loans to other assets. We also assess their performance during periods of financial-market stress as well as periods of rising rates and inflation. Finally, we discuss the risks associated with owning leveraged loans. What Are Leveraged Loans? Leveraged loans are a type of syndicated loan made to sub-investment-grade companies. Generally, these firms are highly indebted, with low credit ratings. A syndicated loan is structured, arranged, and administered by one or several commercial or investment banks.1 The majority of these loans are senior secured loans and are based on a floating rate, mostly LIBOR plus a premium (more than 150-200 bps) to account for their riskiness as well as to attract non-bank institutional investors. The interest rates on these loans adjust at regular intervals to reflect changes in short-term interest rates; this constitutes a benefit for investors worried about rising rates. Definitions vary when it comes to categorizing leveraged loans. Some group them based on the borrower’s riskiness and their credit rating. Others consider leverage metrics such as debt-to-capital and debt-to-EBITDA. Other classifications look at the spread at issuance or the purpose of the fund raising, which can include funding mergers and acquisitions (M&A), leveraged buyouts (LBOs), refinancing existing debt, or general funding. Over the past five years, approximately 50% of US leveraged loans issued were for refinancing purposes (Chart 1, panel 1). Within the three categories, LBO financing is deemed the riskiest, and this is reflected in its higher spread (Chart 1, panel 2). The leveraged-loan market became particularly popular in the mid-1980s as M&A activity was soaring (Chart 2). Chart 1Uses Of Leveraged Loans Chart 2The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth There are two common types of financing facilities:2 Term loans: An agreement to borrow a sum of money that is paid back over a certain payment schedule. These loans are mainly provided by non-bank entities. Revolving facilities: A type of loan that can be repeatedly drawn upon and repaid. These loans are mostly originated and held by banks. Estimates for the size of the leveraged-loan market vary depending on which criteria and definitions are used. The size of the leveraged-loan market, following rapid growth since the beginning of the past decade, is estimated to be over $1.2 trillion as of Q2 2020.3 While this represents only a small portion of overall corporate debt (it is only 15% the size of the corporate bond market), the interconnections between key market participants and the role of banks in the market has caught the attention of several regulators such as US Treasury Secretary Janet Yellen, debt investors such as Howard Marks, and international institutions such as the Bank For International Settlements (BIS). The focus of their concerns has been on the declining credit standards for leveraged loans – particularly, the increase in issuance of “covenant-lite” (cov-lite) loans, inconsistent definitions of EBITDA in loan agreements, the growth in use of “EBITDA add backs”,4 and the accuracy of leveraged-loan ratings.5 We discuss some of those concerns in the Risks section. Table 1Risky Loans Are Mainly Held By Non-Bank Entities… Over the past several decades, the role of banks in providing capital to the leveraged loan market has shrunk and has been replaced by non-bank lenders such as mutual funds, hedge funds, insurance companies, and asset managers.6 Data by the Shared National Credit (SNC) program7 shows that non-bank entities in the US now hold close to 83% of all non-investment-grade term loans (Table 1). Moreover, estimates by the Bank of England8 (BoE) show that a quarter of the global stock of leveraged loans (which it estimates at close to $3.4 trillion) is held through collateralized loan obligations (CLOs)9 and approximately half is owned by non-bank institutions. In turn, those non-bank institutions hold a significant portion of CLOs – particularly the riskier tranches. This is not to say that banks are not exposed to leveraged loans. But banks predominantly invest in the highest, AAA, tranche of CLOs, and investment-grade loans.10 Riskier-rated loans are held by CLOs, mutual funds, and other lenders such as hedge funds (Chart 3).11 Chart 3…Particularly Those Rated Below BB Historical Risk And Return Chart 4Leveraged Loans' Relative Performance Moves With Interest Rates Since 1997, leveraged loans12 have returned an annualized 4.9%, 25 basis points higher than US Treasurys and approximately 100 and 200 basis points less than US investment-grade and high-yield bonds, respectively. They have underperformed US equities by an annualized 400 basis points over the same period. Declining rates over the past two decades are the most likely reason leveraged loans have underperformed their fixed-rate counterparts. The relative performance of leveraged loans to investment-grade bonds has closely tracked the trajectory of Treasury yields (Chart 4). While the case is not as clear for relative performance against high-yield bonds, the trend is similar. However, on a risk-adjusted return basis, due to reduced volatility, leveraged loans did outperform both equities and high-yield corporate bonds (Table 2). We nevertheless think that volatility is likely understated given the elevated kurtosis. The larger negative skew and excess kurtosis could indicate higher probabilities of large negative returns (Chart 5).   Table 2Historical Risk-Return Characteristics Chart 5Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Why Should Investors Consider Leveraged Loans? Chart 6Rising Rates Support Higher Return From Leveraged Loans... Our US bond strategists have showed that the odds of leveraged loans outperforming fixed-rate high-yield bonds increase when certain criteria are in place – particularly when valuations are tilted in loans’ favor, and Treasury yields are rising.13 Only the latter criterion is true currently. Year-to-date, leveraged loans have returned 2.2%, higher than the -3.2%, -3.4%, 1.6%, and -3.4% from US Treasurys, investment-grade bonds, high-yield bonds, and emerging markets sovereign debt, respectively (Chart 6). During the same period, Treasury yields rose by 65 basis points. We find that periods of rising Treasury yields are associated with increased flows into the asset class (Chart 7). More interestingly, leveraged loans outperform junk bonds when Treasury yields rise faster than what is discounted in the forwards curve over the following 12 months (Chart 8). Chart 7...As Well As Increased Fund Flows Chart 8Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve     This does not seem to be the case today, however, with the 5-year, 1-year forward about 40 basis points higher than the current 5-year Treasury yield. This is in line with our view that rates are unlikely to rise substantially over the next 6-to-12 months. Inflation, beyond a temporary spike over the next few months, should remain subdued, at least until employment is back to a level which would put upward pressure on wages. This is unlikely before 2023. It is also important to consider the potential trajectory of monetary policy as well as changes in long-term yields. The Fed, through its dot plot, is signaling no increase in the Fed Funds Rate before 2024, but the market is becoming worried about inflationary pressures and pricing in an earlier Fed hike. We believe it unlikely that the Fed will raise rates ahead of what the market expects, unless the labor market returns to “maximum employment” over the next 12 months. The yield on leveraged loans has been lower than on high-yield bonds for most of the period we have data for, except early 2020. Given leveraged loans’ senior position in a firm’s capital structure, it makes sense that their yields are lower. Additionally, the sector composition of the two markets plays a role: Leveraged loans are more exposed to the Technology and Communications sectors and have a limited allocation (averaging 1% over the past seven years) to the Energy sector, unlike high-yield, fixed-rate bonds (where the weight of Energy has averaged 13%) (Chart 9). This was mostly evident when the yield differential collapsed to below -3% during the 2014/2015 oil crash (Chart 10). Chart 9Leveraged Loans’ Sector Weightings Chart 10Loan Spreads Are Not Looking Attractive Chart 11Recent Investor Demand Pushed Up Leveraged Loan Prices The yield differential has, however, been trending upwards since then, and at current prices, upside may be limited. The recent surge in investor demand has pushed down yields on newly issued leveraged loans, moving the average bid price of leveraged loans above its pre-pandemic high (Chart 11). In the next section, we analyze how leveraged loans have behaved during recessions and other periods of financial market stress.   Financial Market Stress Performance In Crises Given the index’s short history, we are able to cover only the past three recessions (the dot-com bubble bust, the Global Financial Crisis (GFC), and the COVID-19 recession). We also look at the 2013 Taper Tantrum and the 2014/2015 oil price shock. In all cases, leveraged loans fell and subsequently recovered along with other fixed-income asset classes. The Taper Tantrum was the most favorable for leveraged loans: 10-year Treasury yields rose by 100 basis points over four months (Chart 12). Table 3 shows that periods of rising rates are a better environment for leveraged loans than those of declining rates. We also looked at a period of Fed tightening and easing cycles – although the timing of easing cycles overlaps with, recessions, dragging down the performance of leveraged loans. We also assess the impact of inflation on leveraged loans using the framework from our Special Report on inflation hedging,14 which decomposed inflation into four quartiles/regimes: Inflation levels below 2.3%, between 2.3% and 3.3%, between 3.3% and 4.9%, and above 4.9%. We add periods of decreasing inflation to our analysis. We note, however, that there was only one period where inflation was over the 4.9% threshold. Chart 12Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress   Table 3Leveraged Loans’ Performance During Different Rate Cycles… Table 4…And Inflation Regimes During periods in the first and second inflation quartiles, leveraged loans, in absolute terms, had the highest average annualized returns, 8.1% and 10% respectively. This makes sense since in those regimes, policy rates are low and bond yields begin to rise given robust growth. Leveraged loans, however, underperformed fixed-rate bonds during those periods. Inflation above 3.3% represents an environment in which the economy begins to overheat and growth to falter. This regime saw leveraged loans outperform high-yield bonds by an annualized 1.5%. Periods of declining inflation also showed moderately positive annualized returns for leveraged loans (Table 4).   Risks Chart 13Corporate Health Has Worsened... The growth of the leveraged loans market reflects multiple trends but, most importantly, a broad increase in corporate leverage, driven by a decline in interest rates and increasing availability of cheap financing. The debt-to-asset ratio of nonfinancial businesses, a gauge of corporate leverage, is at a 20-year high (Chart 13, panel 1). This raises concerns about the overall health of the corporate sector – particularly firms’ ability to service their debt – since the median interest coverage ratio is near a level last seen during the GFC. This measure is even negative for companies within the 25th percentile, meaning companies in that bucket lack funds to maintain their interest payments (Chart 13, panel 2). Trends in the leveraged loan market paint a similar picture. The share of newly issued loans by the most highly levered firms – those with a debt-to-EBITDA ratio of 6x or higher – has reached new highs, hitting 37% of new loans in Q3 2020 (Chart 14). Chart 14…Even For Leveraged Lending Chart 15Cov-Lite Issuances Make Up Almost 80% Of New Issuances The providers of capital are partly to blame. Even with credit standards deteriorating, firms looking for capital were mostly able to find it. The share of cov-lite structures – loans that lack the protective covenants found in traditional loans – continues to grow and now comprises almost 80% of new issuance (Chart 15). Cov-lite loans typically do not have any maintenance covenants, requirements to maintain certain ratios such as leverage or interest-coverage ratios.15 Instead, they feature incurrence covenants which have to be met only if the issuer wants to take particular actions, such as taking on more debt.16 This loosening of credit terms is mostly a function of increased demand, particularly by CLO buyers and other non-bank institutional investors, in an environment of low yields. Some have even warned that vulnerabilities in the leveraged-loan market could cause disturbance to the overall financial system. Particularly, memories of the GFC and worries about the “originate-to-distribute” model – whereby banks originate loans but retain only a fraction on their balance sheets – have led some observers to suggest this could all lead to a risky expansion of credit, and trigger a new financial crisis. Chart 16Leveraged Loans Have Higher Average Credit Ratings… We do not share this skepticism. Banks’ exposure to leveraged loans is mainly via the highest tranches of CLOs. Banks’ liquidity requirements have increased since the GFC, and therefore contagion should be minimal in the event of problems in the loan market. A recent report by the US Government Accountability Office (GAO) did not find evidence that leveraged lending presented a significant threat to financial stability.17 Additionally, almost all leveraged loans are first lien, they have a senior secured position in the capital structure, higher average credit ratings than high-yield bonds (Chart 16), and lower default rates (Chart 17). Moreover, their five-year average recovery rate of 63% tops the 40% of senior unsecured bonds (Chart 18). Chart 17...Lower Default Rates... Chart 18...And Higher Recovery Rates Than High-Yield Bonds   Conclusion In a period of ultra-low interest rates and stretched valuations for risk assets, leveraged loans have emerged as an interesting asset class for investors. Due to lower volatility, leveraged loans have historically produced higher risk-adjusted returns than fixed-rate high-yield bonds. However, volatility is likely understated given elevated levels of kurtosis. Historically, rising Treasury yields and an attractive valuation starting-point provided a signal for leveraged loans’ outperformance. Only one of those two criteria are currently in place. In the next 6-to-12 months, we do not believe rates will rise substantially, making this asset class somewhat unattractive in the short term. The longer-run outlook for leveraged loans, however, is attractive. As inflation, and therefore rates, rise over the next two-to-three years, a moderate allocation to leveraged loans might be a useful hedge for investors.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1 Please see “LCD Loan Primer – Syndicated Loans: The Market and the Mechanics,” S&P Global Market Intelligence. 2 Please see “Leverage Lending FAQ & Fact Sheet,” SIFMA, February 2019. 3 Please see “Federal Reserve Financial Stability Report,” November 2020. 4 “EBITDA add backs” add back expenses and cost savings to earnings and could inflate the projected capacity of the borrowers to repay their loans. 5 Please see Todd Vermilyea, “Perspectives On Leveraged Lending,” The Loan Syndications and Trading Association 23rd Annual Conference, New York, October 24, 2018. 6 Please see “Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, Chapter 1,” IMF, April 2019. 7 The SNC Program is an interagency program designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions. The SNC Program is governed by an interagency agreement among the three federal bank regulatory agencies - the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office Of the Comptroller Of The Currency (OCC). 8 Please see “Financial Stability Report,” Bank of England, August 2020. 9 CLOs are asset-backed securities issued by a special purpose vehicle which acquire a portfolio of leveraged loans. 10 Please see “Turns Out Leveraged Loans Aren’t a Systemic Risk After All,” Bank Policy Institute, February 8, 2020. 11 Please see Seung Jung Lee, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, “The U.S. Syndicated Term Loan Market: Who holds what and when?”, November 25, 2019. 12 For the purpose of this report, we use the S&P/LSTA Leveraged Loan Index, which tracks the market-weighted performance of US dollar-denominated institutional leveraged loan portfolios. 13 Please see US Bond Strategy Report, “The Price Of Safety,” dated January 27, 2015. 14 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 15 Please see Eric Goodison And Margot Wagner, Paul, Weiss, Rifkind, Wharton & Garrison Llp, “Covenant-Lite Loans: Overview,” August 2019. 16 Please see Scott Essexx, Alexander Ott, Partners Group, “The Current State Of The Leveraged Loan Market: Are There Echoes Of The 2008 Subprime Market?”, March 2019. 17 Please see “Financial Stability: Agencies Have Not Found Leveraged Lending To Significantly Threaten Stability But Remain Cautious Amid Pandemic,” United States Government Accountability Office, December 2020.

Highlights Chart of the WeekThe Bond Bear Mantle Being Passed To Canada? US Treasuries: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remains bond bearish and the Fed is likely to begin preparing the market later this year for a tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk of the Bank of Canada shifting to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying – perhaps even before the Fed does the same (Chart of the Week). Downgrade Canadian government bonds to underweight in global fixed income portfolios. US Treasuries: The Pause That Refreshes Chart 2UST Yield Uptrend Has Paused After leading the global government bond market selloff over the past several months, US Treasury yields have calmed down of late. The 10-year Treasury yield is down 14bps from the most recent peak of 1.74% reached March 31, while the 30-year Treasury yield is down 16bps from the peak of 2.45% reached on March 18. These moves have been concentrated in the real yield component, with inflation breakevens stable, as the 10yr and 30yr TIPS yields are down -15bps and -20bps, respectively, since the dates of those peaks in nominal yields (Chart 2). The drift lower in US yields has occurred in the face of an explosive surge in US economic data. Retail sales rose +9.8% in March compared to February and a staggering +27.7% on a year-over-year basis. The Fed’s regional manufacturing surveys showed very robust results for April, with the New York Empire State index hitting the highest level since October 2017 and the Philadelphia Fed headline index surging to a level last seen in 1973. This follows the very strong payrolls and ISM data for March that came out in early April. Yet the US economic data is not unanimously positive. The latest readings from the University of Michigan consumer confidence and NFIB small business optimism surveys both remained well below pre-pandemic peaks (Chart 3). Annual core CPI inflation only inched up 0.2 percentage points in March to 1.6%, a tepid move compared to the base effect driven surge that took year-over-year headline CPI inflation from 1.7% in February to 2.6%. Chart 3Some Mixed Messages From Recent US Data Chart 4Fewer Positive US Data Surprises The overall flow of US economic data has been disappointing versus elevated expectations, as evidenced by the almost uninterrupted decline in the Citigroup US data surprise index since peaking in July of 2020 (Chart 4). This indicator reliably correlated to the momentum of US Treasury yields prior to the COVID-19 outbreak and now, given the bullish growth combination of vaccine optimism and fiscal stimulus, the bond market’s focus is returning to how US data evolves versus expectations - and what that means for the Fed’s future moves on monetary policy. The most senior leadership at the Fed continues to send a consistent message on policy, with no rate hikes expected before 2024 and no hints at when the tapering of quantitative easing (QE) could begin. Yet some Fed officials have started to be a bit more vocal about their comfort level with the current accommodative policy stance and the associated risks to financial stability and inflation. Last week, Dallas Fed President Robert Kaplan noted that he would like to see the Fed begin to withdraw its support for the economy “at the earliest opportunity”. St. Louis Fed President James Bullard was even more specific, noting that once the share of vaccinated Americans reaches “herd immunity” levels of 75-80%, it will be time for the Fed to debate tapering QE. At the moment, however, there is no need for the Fed to move preemptively. Our Fed Monitor - comprised of economic, inflation and financial market data that would signal pressure for the Fed to ease or tighten policy – is at a neutral level (Chart 5). Our 12-month Fed discounter, which measures the change in interest rates over the next year that is priced into the US overnight index swap (OIS) curve, is at 7bps, consistent with a stand-pat Fed. The latest read this month from the New York Fed’s Survey of Primary Dealers (and Survey of Market Participants) showed no change in the median longer-run expectation for the fed funds rate of 2.25% that has prevailed over the past year (middle panel) – despite a sharp recovery in US growth expectations. Chart 5UST Valuations A Bit Stretched The market pricing of the Fed’s next move is still relatively benign, with liftoff not expected until February 2023. This suggests that a pause in the trend of rising Treasury yields was essentially the market getting a bit ahead of itself in pricing in higher longer-term yields. This can be seen by looking at various valuation measures. For example, the 5-year/5-year forward Treasury yield now sits at 2.4%, which is at the high end of the range of longer-run fed funds rate expectations from the Primary Dealer survey. Also, various measures of the term premium on 10-year Treasury yields have returned to the above-zero levels last seen during the Fed’s 2016-2018 rate hiking cycle – even with the Fed not signaling any need to tighten policy in response to rising inflation expectations. Despite these signs of stretched near-term UST valuation, there is still no sign of major global bond investors being comfortable with increasing exposure to Treasuries. For example, despite yields on 10-year Treasuries (hedged into euros and yen) looking historically attractive compared to the near-zero yields on JGBs and sub-zero yields on German Bunds, the US Treasury’s capital flow data shows that foreign investors remain net sellers of Treasuries (Chart 6). It is possible that those foreign buyers need more evidence of a sustained decrease in US bond volatility before moving money into US Treasuries, where duration losses from higher US yields could wipe out the yield pickup from moving into US bonds. While valuations are a bit stretched for Treasuries, technicals appear very oversold. Both the deviation of the 10-year Treasury yield from its 200-day moving average, and the 6-month rate of change of the Bloomberg Barclays US Treasury total return index, are at levels seen only four previous times since 2010 (Chart 7). The JP Morgan client duration positioning surveys and the Market Vane Treasury sentiment index are also approaching post-2010 bearish extremes. It should be noted that both of those measures reached even more bearish extremes during the latter half of the Fed’s 2026-2018 tightening cycle, so there is potential for Treasury sentiment to become even more bearish once the Fed starts to tighten monetary policy – a scenario looking increasingly likely over the next 6-12 months. Chart 6No Foreign Bid For USTs (Yet) Chart 7USTs Are Technically Oversold We continue to expect a robust US economy and rising inflation to force the Fed to begin preparing the market in the latter half of 2021 for QE tapering in 2022, with the first rate hike of the next tightening cycle coming in late 2022. As that outcome appears largely consistent with current market pricing, amid oversold technicals, it is likely that Treasury yields will continue to move sideways over at least the next few weeks. Yet there is little to suggest that yields have peaked and are about to enter a new downtrend, given the accelerating pace of US vaccinations that is boosting optimism on an eventual end to the US leg of the pandemic. Stay defensive on US Treasury exposure, as the cyclical rise in yields is not over yet. Bottom Line: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remain bond bearish and the Fed is likely to begin preparing the market later this year for tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: Downgrade To Underweight In a Special Report published back in February along with our colleagues at BCA Foreign Exchange Strategy, we outlined the case for placing Canadian government debt on “downgrade watch” in global fixed income portfolios.1 We expected Canadian bond yields to continue rising along with the rise in global bond yields and, hence, we maintained our below-benchmark recommended duration exposure within Canada. Chart 8Canada: A High Beta Bond Market Once Again However, we concluded that it was too soon to shift to a full-blown underweight stance on Canadian government bonds with COVID-19 cases still raging through the country, the vaccination program off to a very slow start, and the Bank of Canada (BoC)’s QE program preventing Canadian bonds from returning to their usual “high-beta” status within developed economy bond markets. It now appears that we were too cautious on that front. Canadian government bonds have been one of the worst performing markets year-to-date within the Bloomberg Barclays Global Government bond index, delivering a local currency return of –4.1% - worse than the -3.5% return earned on US Treasuries so far in 2021.2 It is clear that the Canadian government bonds are once again a market more sensitive to global interest rate moves (Chart 8). In that February Special Report, we laid out three factors that could prompt the BoC to move to a less dovish, and more bond bearish, monetary policy stance faster than we expected. Much of that list has already started to come to fruition. 1) Good News On The Vaccine Rollout Sadly, Canada is suffering a third wave of COVID-19 cases that has resulted in the nation’s most populous province, Ontario, implementing the harshest lockdown yet seen during the pandemic. Yet the pace of vaccinations has also been rising with the share of Canadians receiving at least one jab is now 21% (Chart 9) - higher than that of the overall European Union (EU). Canada is now administering more daily vaccinations than both the UK and EU. The quickening pace of vaccinations is already providing a major lift to Canadian economic confidence. The Bloomberg Nanos consumer confidence index is at an all-time high (Chart 10), while the BoC’s Business Outlook Survey for the spring of 2021 was incredibly solid. Two-thirds of firms in that survey expect sales to exceed pre-pandemic levels, even with the latest upturn in COVID-19 cases. Chart 9Canadian Vaccine Rollout Improving Chart 10Booming Optimism The BoC’s Q1/2021 Consumer Survey showed similar levels of optimism. 74% of Canadians surveyed aged 25-54 are planning to engage in levels of social and economic activities equal to, or greater than, those seen prior to the pandemic once the majority is vaccinated (Chart 11). A net majority (18%) of those surveyed plan to spend more on the types of “high-touch” service spending unavailable during the pandemic, like travel, movies and dining in restaurants, once a majority is vaccinated (Chart 12). Chart 11Canadians Are Ready To Have Fun Once Again All of the Canadian survey data is sending a clear message: a faster vaccine rollout will leader to much faster spending by consumers and businesses. 2) Signs Of Financial Stability Risks Highly-indebted Canadians' love affair with real estate has always concerned the BoC. While a combination of cutting policy interest rates to zero and ramping up QE helped stabilize Canadian financial markets during the 2020 pandemic shock, it has also set off a new surge of housing speculation. According to the Bloomberg Nanos consumer survey, 67% of Canadians now expect house prices to appreciate. The demand for homes has given a lift to the Canadian economy through a surge in new housing starts (residential investment is 8% of Canadian real GDP), while pushing national house price inflation back above 10% (Chart 13). Chart 12A Surge In "High-Touch" Spending Awaits Canadian Herd Immunity As already indebted Canadian households pile on more debt to partake in another national home-buying party, the BoC must now concern itself with the potential financial stability risks from a too-rapid rise in housing values. Chart 13Yet Another Canadian Housing Boom In a recent speech, BoC Deputy Governor Toni Gravelle noted that the BoC had to introduce QE in 2020 to help fight COVID-related dysfunction across a variety of Canadian financial markets, including government bonds where liquidity dried up.3 Gravelle also noted that the BoC would begin to dial back QE once it was clear that financial markets no longer needed the support from QE. With Canadian equities booming and Canadian corporate bond spreads near the lowest levels of the past decade (Chart 14), it seems clear that the BoC can begin dialing back its government bond purchase program if it is no longer necessary and likely fueling another housing bubble. 3) Additional Large Fiscal Stimulus The governing Canadian Liberal government of Prime Minister Justin Trudeau delivered a massive amount of fiscal stimulus to the pandemic-stricken Canadian economy in 2020. In the 2021/22 federal budget announced yesterday, another huge burst of spending was introduced, equal to C$101bn or 4.2% of Canadian GDP over the next three years. The spending was described as another COVID relief package, but included many long-term programs like national child care, raising the minimum wage and boosting green investments. According to the projections from the latest IMF World Fiscal Monitor, the “fiscal thrust” for Canada – the change in the cyclically-adjusted primary budget balance as a share of GDP - was projected to turn from a stimulus of +9% in 2020 to a drag of -2% in 2021 (Chart 15). The spending announced in the latest budget will effectively eliminate that drag for the next three years. This will provide a major lift to an economy already likely to see booming post-pandemic growth. Chart 14BoC QE No Longer Necessary Chart 15No Fiscal Drag Now Expected In 2021 Chart 16Canadian Real Yields Are Too Low Given the combination of expanding vaccinations, surging confidence, a renewed housing boom and soaring financial markets, it will be difficult for the BoC to maintain its current policy settings for much longer. This is a central bank that engaged in QE reluctantly last year and numerous BoC officials have stated – even in the worst days of the global pandemic - that they would begin to remove accommodation once it was no longer needed. Interest rate markets have already moved to price in a full-blown BoC tightening cycle. The Canadian OIS curve now discounts “liftoff” (a full 25bp rate hike) in October 2022, with 163bps of rate hikes priced in to the end of 2024 (Chart 16). The projected path of rates is below the BoC’s inflation forecasts to 2023. Thus, the implied Canadian real policy rate is expected to remain negative over the next two years – even though the BoC estimates that the neutral policy rate range is 1.75% to 2.75%, or -0.25% to +0.75% in real terms after subtracting the midpoint of the BoC’s 1-3% inflation target band. In other words, Canadian interest rate markets are vulnerable to any BoC shift in a less dovish direction, as seems increasingly likely sometime in the next few months. Our BoC Monitor is rapidly moving out of the “easier policy required” zone (Chart 17), and the rapid improvement in the Canadian employment situation suggests the BoC will be under more pressure to begin signaling a path towards withdrawing policy accommodation. This will start with an announced tapering of QE purchases, perhaps even ahead of any signals from the Fed that it is doing the same (Chart 18). This justifies a more cautious stance on Canadian fixed income exposure. Chart 17Downgrade Canadian Government Bonds To Underweight Chart 18Could The BoC Start Tapering Before The Fed? While a BoC tapering announcement before the Fed would likely put upward pressure on the Canadian dollar versus the US dollar, that would be something the BoC could live with if the economy was rapidly gaining strength – especially as our currency strategists believe the “loonie” to be undervalued. Thus, we are formally downgrading our strategic recommended allocation to Canadian government bonds to underweight (2 out of 5, see table on page 16). We are also maintaining our recommended below-benchmark duration exposure within dedicated Canadian bond portfolios. We are also cutting the allocation to Canada to underweight in our model bond portfolio and placing the proceeds in both, the US and core Europe (see pages 14-15). Bottom Line: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk that the Bank of Canada shifts to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying. Downgrade Canadian government bonds to underweight in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com and gfis.bcaresearch.com. 2 That Canadian return is virtually the same after hedging into US dollars, hence that local currency return can be compared to the US dollar denominated Treasury market return. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Global Inflation: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Inflation-Linked Bond Allocations: ILB valuations, however, are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB. Feature Chart of the WeekMarkets Remain Unconcerned About An Inflation Overshoot The global reflation trade over the past year has been highly rewarding to investors. Equity and credit markets worldwide have delivered outstanding returns on the back of highly stimulative monetary and fiscal policies implemented to deal with the negative economic effects of COVID-19. The global INflation trade has also paid off for investors in inflation-linked bonds (ILBs), which have outperformed nominal government debt across the developed economies dating back to last spring. The rising trend for global inflation breakevens remains intact, but is approaching some potential resistance points. A GDP-weighted average of 10-year breakeven inflation rates among the major developed economies is just shy of the 2% level that has represented a firm ceiling over the past decade (Chart of the Week). At the same time, the Bloomberg consensus forecast for headline CPI inflation for that same group of countries calls for an increase to only 1.8% by year-end before slowing to 1.7% in 2022. The latest forecasts from the IMF are similar, calling for headline inflation in the advanced economies to reach 1.6% in 2021 and 1.7% in 2022. If those modest forecasts for realized inflation come to fruition, then there is likely not much more upside in inflation breakevens, in aggregate. Country selection within the ILB universe will become more important over the next 6-12 months, as divergences in growth, realized inflation and central bank reactions will lead to a more heterogeneous path for global inflation breakevens. Underlying Inflation Backdrop Still Supports Rising Breakevens On a total return basis, ILBs enjoyed an extended run of success prior to this year. The cumulative total return of the asset class (in local currency terms) between 2012 and 2020 was a whopping 61% in the UK, 25% in Canada, 22% in the US and 21% in the euro area (aggregating the individual countries in the region with inflation-linked bonds). However, the absolute performance of ILBs has been more disperse on a country-by-country basis so far in 2021. ILBs are down year-to-date in Canada (-6.2%), the UK (-5.0%) and the US (-1.4%). On the other hand, euro area ILBs have delivered a positive total return of +0.5% so far in 2021. Real bond yields have climbed off the lows in the US, UK and, most notably, Canada where the overall index yield on the Bloomberg Barclays inflation-linked bond index is now in positive territory for the first time since before the pandemic started (Chart 2). At the same time, real bond yields have been drifting lower in the euro area. These real yield moves are related to shifting perceptions of central bank responses to the global growth upturn. For example, pricing in overnight index swap (OIS) curves have pulled forward the timing and pace of future interest rate increases in the US and Canada – i.e. real policy rates will become less negative - while there has been comparatively little change in euro zone rate expectations. While the absolute returns for ILBs have become less correlated, the relative trade between nominal and inflation-linked government bonds in all countries remains intact. 10-year breakeven inflation rates have been steadily climbing in the US and UK, while depressed Japanese breakevens have crept modestly higher (Chart 3). Even Europe, where inflation has remained subdued for years, has seen a significant shift higher in inflation breakevens. (Chart 4). The turn in breakevens has occurred alongside a major change in investor perceptions of future inflation, with surveys like the ZEW showing an overwhelming majority of financial professionals expecting higher inflation in the US, Europe and the UK. Chart 2A Fading Bull Market In Inflation-Linked Bonds Chart 3A Solid Recovery In Inflation Expectations Chart 4European Inflation Expectations Starting To Normalize Inflation forecasts have shifted in response to faster global growth expectations on the back of vaccine optimism and aggressive US fiscal stimulus. Yet inflation forecasts remain modest compared to the huge growth figures expected for 2021 and 2022. In its latest World Economic Outlook published last week, the IMF upgraded its global real GDP forecast to 6.0% for 2021 and 4.4% for 2022. This represented an increase of 0.5 and 0.4 percentage points, respectively, from the last set of forecasts published back in January. While growth upgrades occurred across all major developed and emerging economies, the biggest upgrades came in the US and Canada, for both 2021 and 2022. As a result, the IMF projects the output gap in both countries to turn positive over 2022 and 2023, and be nearly closed in core Europe, Australia and Japan (Chart 5). The IMF is not projecting a major inflation surge on the back of those upbeat growth forecasts, though. While headline inflation in the US is expected to climb to 2.3% in 2021 and 2.4% in 2022, the same measure in Canada is only projected to rise to 1.7% and 2.0% over the same two years. European inflation is expected to remain subdued, reaching only 1.4% this year and drifting back to 1.2% in 2022 despite real GDP growth averaging 4.1% over the two-year period. The IMF attributes the benign inflation outcomes, even in the face of booming growth rates and the rapid elimination of output gaps, to the structural disinflationary backdrop for so-called “non-cyclical” inflation (Chart 6). The IMF defines this as the components of inflation indices that are less sensitive to changes in aggregate demand. The IMF estimates show that the contribution from non-cyclical components to overall inflation in the advanced economies had fallen to essentially zero at the end of 2020. Chart 5A Big Expected Narrowing Of Output Gaps Chart 6Non-Cyclical Components Still Weighing On Global Inflation There is considerable upside risk for the more cyclical components of inflation that could result in inflation overshooting the IMF projections (Chart 7). Chart 7Cyclical Backdrop Is Inflationary For example, in the US, the Prices Paid component of the ISM Manufacturing index remains elevated at post-2008 highs, while the year-over-year change in the Producer Price Index soared to 6% in March. Across the Atlantic, the European Commission business and consumer surveys have shown a big surge in the net balance of respondents expecting higher inflation in manufacturing and retail trade. Previous weakness in the US dollar and surging commodity prices are playing a major role in this rapid pick-up in price pressures seen in many countries. Given the current backdrop of strong global growth expectations, with actual activity accelerating as vaccinations increase and more parts of the global economy reopen, inflation pressures are unlikely to fade in the near term. With realized inflation rates set to spike due to base effect comparisons to the pandemic-fueled collapse one year ago, the upward pressure on global ILB inflation breakevens will persist in the coming months – especially with breakevens still below levels that would prompt central banks to turn less dovish sooner than expected. Bottom Line: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Assessing Value In Developed Market Inflation-Linked Bonds Chart 8USD Outlook Now More Mixed Although the current backdrop remains conducive to a continuation of the rising trend in global ILB breakevens, there are factors that could begin to slow the upward momentum. The future path of the US dollar is now a bit less certain (Chart 8). While the DXY index is still down 7.4% compared to a year ago, it is up 2.4% so far in 2021. Shorter-term real interest rate differentials between the US and the other major developed markets remain dollar-bearish. At the same time, longer-term real yield differentials have risen in favor of the US (middle panel). Furthermore, US growth is outperforming other developed economies, typically a dollar-bullish factor (bottom panel). Given the usual negative correlation between the US dollar and commodity prices, a loss of downside dollar momentum could also slow the pace of commodity price appreciation. This represents a risk to additional global ILB outperformance versus government bonds. Our GDP-weighted aggregate of 10-year ILB breakevens for the major developed economies is currently just under 2% - levels more consistent with oil prices over $80/bbl than the current price closer to $60/bbl (Chart 9). Chart 9Breakevens Consistent With Much Higher Oil Prices Given some of these uncertainties over the strength of any future inflationary push from a weaker US dollar and rising commodity prices, a broad overweight allocation to ILBs across the entire developed market universe may no longer generate the same strong returns versus nominal government bonds seen over the past year. With the “easy money” already having been made in the global breakeven widening trade, country allocation within the ILB universe has now become a more important dimension for bond investors to consider. To assess the relative attractiveness of individual ILB markets, we turn to a few valuation tools. Our regression-based valuation models for 10-year ILB breakevens in the US, UK, France, Italy, Germany, Japan, Canada and Australia are all presented in the Appendix on pages 14-17. The two inputs into the model are the annual rate of change of the Brent oil price in local currency terms (as a measure of shorter-term inflation pressure) and a five-year moving average of realized headline CPI inflation (as a longer-term trend that provides a structural “anchor” for breakevens based off actual inflation outcomes). We first presented these models in April 2020, but we have now made a change in response to some of the unprecedented developments witnessed over the past year.1 Despite the strong visual correlation between the level of oil prices and inflation breakevens in most countries, we chose to use the annual growth of oil prices, rather than the level, in our breakeven models. This is because we found it more logical to compare a rate of change concept like inflation (and breakevens) to the rate of change of oil. However, the oil input into our breakeven models could produce nonsensical results during periods of extreme oil volatility that did not generate equivalent swings in breakeven inflation rates. A good example of that occurred in 2016, when the annual rate of change of the Brent oil price briefly surged toward 100%, yet 10-year US TIPS breakevens did not rise above 2% (Chart 10). An even bigger swing in oil prices has occurred over the past year, with oil prices up over +200% compared to the collapse in prices that occurred one year ago. Putting such an extreme move into our US model would have pushed the “fair value” level of the 10-year TIPS breakeven to 4% - an implausible outcome given that the 10-year breakeven has never risen to even as high as 3% in the entire 24-year history of the TIPS market. Chart 10Pass-Through Of Extreme Oil Moves Has Limits To deal with this problem, we have truncated the rate of change of oil prices in all our breakeven models at levels consistent with past peaks of breakevens. Going back to the US example, we have “capped” the rate of change of the Brent oil price at +40%, as past periods when oil price momentum was greater than 40% did not translate into any additional increase in TIPS breakevens. We then re-estimated the model using this truncated oil price series to generate fair value breakeven levels. Chart 11A Mixed Impact Of USD Moves On Non-US Breakevens We did this for all eight of our individual country breakeven models and in all cases, truncating extreme oil moves improved the accuracy of the model. Interestingly, we did not truncate the downside momentum of oil prices, as there was no obvious “cut-off” point where periods of collapsing oil prices did not generate equivalent declines in breakevens. Oil prices remain the most critical short-term variable to determine ILB breakeven valuation. While it is intuitive to think that currency movements should also have a meaningful impact on inflation (both realized and expected), the effect is not consistent across countries. For example, euro area breakevens appear to be positively correlated to the euro, while Japanese breakevens rarely rise without yen weakness (Chart 11). One other factor to consider when evaluating the value of breakevens is the possible existence of an inflation risk premium component during periods of higher uncertainty over future inflation. Such uncertainty could result in increased demand for ILBs from investors driving up the price of ILBs (thus lowering the real yield) relative to nominal yielding bonds, leading to wider breakevens that do not necessarily reflect a true rise in expected inflation. A simple way to measure such an inflation risk premium is to compare market-based breakevens to survey-based measures of inflation forecasts taken from sources like the Philadelphia Fed's Survey of Professional Forecasters and the Bank of Canada’s Survey Of Consumer Expectations. The assumption here is that the survey-based measures represent a more accurate (or, at least, less biased) depiction of underlying inflation expectations in an economy. We present these simple measures of inflation risk premia, comparing 10-year breakevens to survey-based measures of inflation expectations, in Chart 12 and Chart 13. Breakevens had been trading well below survey-based measures of inflation expectations after the negative pandemic growth shock in 2020 in all countries shown. After the steady climb in global breakevens seen over the past year, those gaps have largely disappeared, with breakevens now trading slightly above survey based inflation expectations in the US, UK and Australia. Chart 12No Major Inflation Risk Premia In These Markets Chart 13Canadian & Australian Breakevens In Line With Inflation Surveys Chart 14Assessing The Value Of Breakevens In Chart 14, we show the valuation residuals from our 10-year ILB breakeven models, along with two other measures of potential breakeven valuation: a) the distance between current breakeven levels and their most recent pre-pandemic peaks; and b) the difference between breakevens and the survey-based measures of inflation expectations. The model results show that breakevens are furthest below fair value in France, Japan and Germany, and the most above fair value in the UK and Australia. The message of undervaluation from our models is confirmed in the other two metrics for France, Japan, Germany, Canada and Italy. The overvaluation message for Australia is consistent across all three valuation metrics, while the signals are mixed for US and UK breakevens. In Japan, while the combined signals of all three valuation metrics indicate that breakevens are far too low, the very robust positive correlation between Japanese breakevens and the USD/JPY exchange rate implies that a bet on wider breakevens requires a much weaker yen. In Canada, while the 10-year breakeven does appear cheap, the real yield has also climbed faster than any of the other countries over the past several months as markets have rapidly repriced a more hawkish path for the Bank of Canada. Recent comments from Bank of Canada officials have leaned a bit hawkish, hinting at a possible taper of its bond-buying program, as the central bank appears unhappy with the renewed boom in Canadian housing values. An early tightening of monetary conditions would likely cap any additional upside in Canadian inflation breakevens. In Europe, the undervaluation of breakevens is more compelling. The ECB is likely to maintain its dovish policy settings into at least 2023, even if growth recovers later this year as increased vaccinations lead to the end of lockdowns. As shown earlier, European breakevens can continue to rise even if the euro is also appreciating versus the US dollar, especially if growth is recovering and oil prices are rising. Euro area breakevens are likely to continue drifting higher over at least the rest of 2021. Currently in our model bond portfolio, we have allocations to ILBs out of nominal government bonds in the US, France, Canada and Italy, with no allocations in Germany, Japan, Australia or the UK. After assessing our valuation measures, we are comfortable with the ILB exposure in France and Italy and lack of positions in the UK and Australia. We still see the upside case for US breakevens, with the economy reopening rapidly fueled further by fiscal policy, and the Fed likely to maintain its current highly dovish forward guidance until much later in 2021. We are reluctant to add exposure to Japanese ILBs, despite attractive valuations, as we are not convinced that USD/JPY has enough upside potential to help realize that undervaluation of Japanese breakevens. Thus, as a new change to our model portfolio this week that reflects our assessment of ILB breakeven valuations and risks, we are closing out the exposure to Canadian ILBs and adding a new position in German ILBs of equivalent size (see the model bond portfolio tables on pages 18-19). Bottom Line: ILB valuations are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Appendix Chart A1Our US 10-Year Inflation Breakeven Model Chart A2Our UK 10-Year Inflation Breakeven Model Chart A3Our France 10-Year Inflation Breakeven Model Chart A4Our Italy 10-Year Inflation Breakeven Model Chart A5Our Japan 10-Year Inflation Breakeven Model Chart A6Our Germany 10-Year Inflation Breakeven Model Chart A7Our Canada 10-Year Inflation Breakeven Model Chart A8Our Australia 10-Year Inflation Breakeven Model Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q1/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +55bps during the first quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +68bps, led overwhelmingly by our underweight to US Treasuries (+63bps). Spread product allocations underperformed by -11bps, primarily due to an overweight on UK corporates (-8bps). Portfolio Positioning For The Next Six Months: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral. Feature The first quarter of 2021 saw a sharp sell-off in global bond markets on the back of rising growth expectations, fueled by US fiscal stimulus and vaccine optimism. The US was near the front of the pack, with 10-year Treasuries having their biggest first quarter sell-off since 1994. Accommodative financial conditions, fueled by a highly stimulative mix of monetary and fiscal policies and improving sentiment, have lit a fire under a global economy set to reopen from pandemic lockdowns. Going forward, we expect US growth to continue leading the way, with implications for the dollar, commodity prices, and the expected path of policy rates. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the first quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2021 Model Portfolio Performance Breakdown: Steering Clear Of Duration Chart 1Q1/2021 Performance: Bearish UST Bets Pay Off The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -1.83%, dramatically outperforming the custom benchmark index by +55bps (Chart 1).1 This follows modest outperformance in 2020 which was driven largely by overweights on spread product initiated after the pandemic shock to markets. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +68bps of outperformance versus our custom benchmark index while the latter underperformed by -11bps. Our allocations to inflation-linked bonds in the US, Canada and Europe - which were a source of outperformance in 2020 - modestly underperformed this quarter (-2bps) as global real yields finally began to pick up. Our outperformance this quarter was driven overwhelmingly by our decision to go significantly underweight US Treasuries, and to position for a bearish steepening of the Treasury curve, ahead of last November’s US presidential election (Table 2). That resulted in the US Treasury allocation generating a massive +63bps of excess return in Q1/2022 as longer-term US yields surged higher. Table 2GFIS Model Bond Portfolio Q1/2021 Overall Return Attribution The size of the US underweight was unusually large as we maintained only a neutral exposure to the other “high beta” markets that are typically positively correlated to US yield moves, Canada and Australia. Although the returns for those two government bond markets were very similar to that of US Treasuries in Q1, so the choice to stay neutral even with a bearish directional view on US yields did not impact the overall portfolio performance. Overweights to the more defensive “low beta” markets of Germany, France and Japan contributed a combined +4bps. We did see some losses on nominal government bonds in peripheral Europe (Italy: -0.6bps; Spain: -1.9bps), however, with the narrowing in spreads thrown off by a botched vaccine rollout. In spread product, underperformance came from overweights to UK investment grade corporates (-8bps), US CMBS (-4bps), and EM USD-denominated corporates (-2bps). This was despite the fact that spreads for UK corporates remained flat while US CMBS spreads actually narrowed. These losses were slightly offset by the overweight to lower-rated US high-yield (+3bps) and underweight to US agency MBS (+2bps). Our spread product losses, in total return terms, highlight the importance of considering duration risk when making a call on spread product, especially at a time when sovereign yields are rising and spreads offer little “cushion”. Duration also played a big part in nominal government bond outperformance, with a whopping +43bps of our total +55bps outperformance concentrated in just US Treasuries with a maturity greater than 10 years. In other words, overweighting overall global spread product and underweighting government bonds still generated major portfolio outperformance, even if there was a more mixed bag of returns within that credit overweight. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2021 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2021 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+43bps), maturity between 7 and 10 years (+11bps), and with a maturity between 5 and 7 years (+7bps) Overweight US high-yield (+3bps) Underweight US agency MBS (+2bps) Overweight Italian inflation-indexed BTPs (+2bps) Biggest Underperformers: Overweight UK investment grade corporates (-8bps) Overweight US agency CMBS (-4bps) Overweight Spanish government bonds (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2021 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. On that front, our portfolio allocations performed exceptionally well in Q1. In total return terms, the global bond market sell-off was a disaster for both government bonds and spread product. US high-yield, one of our longer-standing overweights, was the only sector to emerge unscathed, delivering a positive return of +42bps. Within our government bond allocation, the “defensive” markets—Japan (-44bps), Germany, (-261bps) and France (-371bps)—were nevertheless shaken by rising yields. On the other hand, we limited our downside by maintaining a neutral stance on the higher beta markets such as Canada (-406bps), New Zealand (-415bps), and the UK (-1389bps). Gilts sold off especially sharply as the UK outperformed global peers on COVID-19 vaccinations while inflation expectations continued to pick up. Our two underweights, US Treasuries (-426bps) and European high-yield (-426bps), were prescient. The latter market was one we chose to underweight given that spreads didn’t offer nearly enough compensation on a default-adjusted and breakeven basis. Bottom Line: Our model bond portfolio outperformed its benchmark index in the first quarter of the year by +55bps – a positive result driven by our underweight allocation to the US Treasury market and overall below-benchmark global duration stance. Future Drivers Of Portfolio Returns & Scenario Analysis Chart 5More Growth-Driven Upside For Global Yields Ahead Looking ahead, the performance of the model bond portfolio will continue to be driven predominantly by the future moves of global government bond yields, most notably US Treasuries. Our most favored leading indicators for global bond yields continue to signal more upside over at least the next six months (Chart 5). Our Global Duration Indicator, comprised of measures of future economic sentiment and momentum, remains at an elevated level. The ongoing climb in the global manufacturing PMI, which typically leads global real bond yields by around six months, suggests that the recent uptick in real yields can continue into the second half of 2021. We are still maintaining a bias towards bearish yield curve steepening across all the countries in the model bond portfolio. It is still far too soon to see bearish flattening of yield curves given the dovish bias of global central banks, many of which are actively targeting an overshoot of their own inflation targets. The US will be the first central bank to see any bearish flattening pressure, as the market more aggressively pulls forward the liftoff date of the next Fed tightening cycle in response to strong US growth, but that is an outcome we do not expect until well into the second half of 2021. With regards to country allocations within the government bond segment of the model bond portfolio, we continue to focus our maximum underweight on the US, while limiting exposure to the markets that are more sensitive to changes in US interest rates (Chart 6). Those “lower yield beta” markets (Germany, France and Japan) will continue to outperform the higher beta markets (Canada, Australia) over the latter half of 2021. We currently have Canada on “downgrade watch”, as economic momentum is accelerating and the housing bubble looks to be reflating, both of which will make the Bank of Canada turn more hawkish shortly after the Fed does. We are more comfortable keeping Australia at neutral, as Australian inflation is likely to remain too underwhelming for the Reserve Bank of Australia to turn less dovish and risk a surge in the Australian dollar. UK Gilts are a more difficult case, atypically acting like a lower beta market over the past few years. As we discussed in a Special Report published last month, we attribute the declining Gilt yield beta to the rolling shocks the UK has suffered over the past thirteen years – the 2008 global financial crisis, the 2012 euro area debt crisis, Brexit and, now, COVID-19 – that have hamstrung the Bank of England’s ability to try even modest interest rate hikes.2 With the impact of those shocks on UK growth now diminishing, we see the central bank under greater pressure to begin normalizing UK monetary policy over the couple of years. We downgraded our cyclical stance on UK Gilts and UK investment grade corporates to neutral from overweight in that Special Report and, this week, we are making the same reduction in UK weightings in our model bond portfolio (see the portfolio tables on pages 20-21). After that change, the overall duration of the model bond portfolio remains below that of the custom benchmark index, now by -0.75 years (Chart 7). Chart 6Low-Beta Markets Will Continue To Outperform USTs Chart 7Overall Portfolio Duration: Stay Below Benchmark We continue to see the dovish bias of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt (Chart 8). Yes, the “easy money” has been made betting on a recovery of inflation expectations from the bombed-out levels seen after the COVID-19 recession in 2020. However, within the major developed economies with inflation-linked bond markets, 10-year breakevens have already climbed beyond the pre-pandemic levels of early 2020 (Chart 9). The next targets are the previous cyclical highs seen in 2018 (and 2019 for the UK). Chart 8Dovish Central Banks Still Positive For Inflation-Linked Bonds Chart 9Inflation Breakevens Returning To Past Cyclical Peaks Chart 10Still A Supportive Backdrop For Global Corporates The 10-year US TIPS breakeven is already past that 2018 peak of 2.18%, and with the Fed showing no sign of concern about US growth and inflation accelerating, the 10-year US breakeven should end up moving into the high end of our expected 2.3-2.5% target range before the Fed begins to turn less dovish. Thus, we are maintaining a core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy, France and Canada. The same aggressive easing of global monetary policy that has been good for relative inflation-linked bond performance continues to benefit global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England remains an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). With the combined balance sheet now expanding at a 55% pace, corporate bonds are still likely to continue to outperform government debt over the remainder of 2021. Much of that expected return outperformance of corporates will come via carry rather than spread compression, though. Our preferred measure of the attractiveness of credit spreads, the historical percentile ranking of 12-month breakeven spreads, shows that only US high-yield spreads are above the bottom quartile of their history among the credit sectors in our model portfolio (Chart 11). Given the absence of spread cushion in those other markets, we are maintaining an overweight stance on US high-yield in the model bond portfolio – especially versus euro area high-yield where we are underweight - while staying neutral investment grade credit in the US and Europe. Chart 11US High-Yield: The Last Bastion Of Attractive Spreads Within the euro area, we continue to prefer owning Italian government bonds over investment grade corporates, given the European Central Bank’s more explicit support for the former through quantitative easing (Chart 12). We expect Italian yields and spreads to converge down to Spanish levels, likely within the next 6-12 months, while there is limited downside for euro area investment grade spreads given tight valuations. Chart 12Favor Italian BTPs Over Euro Area IG We are not only looking at relative valuation considerations in developed market credit. Emerging market (EM) USD-denominated credit has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices. We have positioned for that in our model portfolio through an overall overweight stance on EM USD credit, but one that favors investment grade corporates over sovereigns. Now, with the Chinese credit impulse likely to slow in the latter half of 2021 as Chinese policymakers look to rein in stimulus, a slower pace of Chinese economic growth represents a risk to EM credit (Chart 13). The same can be said for the US dollar, which is no longer depreciating with US bond yields rising and the markets questioning the Fed’s dovish forward guidance on future rate hikes (Chart 14). A strong US dollar would also be a risk to the commodity price rally that has supported EM financial assets. Chart 13Global Policy Mix Becoming Less Supportive For EM Chart 14A Stronger USD Is A Risk For EM Corporates Vs Sovereigns Chart 15A Moderate Overweight To Spread Product Vs Government Debt In response to these growing risks to the bullish EM backdrop, we are downgrading our overall EM USD credit exposure in the model bond portfolio to neutral from overweight. We are maintaining our relative preference for EM investment grade corporates over sovereigns, however, within that overall neutral allocation. Summing it all up, we are sticking with a moderately overweight stance on global spread product versus government debt in the model portfolio, equal to four percentage points (Chart 15). That overweight comes entirely from the US high-yield allocation. After the changes made to our UK and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 41bps (Chart 16). This is an unsurprising outcome given that the current positioning is focused so heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral. That will change as 2021 progresses but, for now, our highest conviction views are in US fixed income. One final point – the relatively concentrated positioning leaves the portfolio “flat carry”, with a yield roughly equal to that of the benchmark index (Chart 17). Chart 16Limited Use Of Portfolio 'Tracking Error' Chart 17Model Portfolio Yield Close To Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the UK and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. 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: Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries Base case: Ongoing global vaccinations lead to more of the global economy reopening over the summer, with excess savings built up during the pandemic – augmented by ongoing fiscal support – starting to be spent. US economic growth will be most robust out of the major economies, given the additional boost from fiscal stimulus, while China implements actions to slow credit growth and the euro area lags on vaccinations. The Fed stands its ground and maintains no rate hikes until at least 2023, and US TIPS breakevens climb to levels consistent with the Fed’s 2% inflation mandate (2.3-2.5%). The US Treasury curve continues to bear-steepen, with the 10-year US yield rising to 2%. The VIX falls to 15, the US dollar is flat, the Brent oil price rises +5%, and the fed funds rate is unchanged at 0%. Optimistic case: A rapid pace of global vaccinations leads to booming growth led by the US but including a reopening euro area. Chinese policymakers tighten credit by less than expected. Markets begin to pull forward the timing and pace of future central bank interest rate hikes, most notably in the US but also in the other countries like Canada and the UK. Real bond yields continue to climb globally, but inflation breakevens stay elevated. The steepening trend of the US Treasury curve ends, and mild bear flattening begins with the 10-year reaching 2.2% and the 2-year yield climbing to 0.4%. The VIX stays unchanged at 18, the US dollar rises +5%, the Brent oil price climbs +2.5% and the fed funds rate stays unchanged. Pessimistic case: Setbacks on the pandemic, either from struggles with vaccine distribution or a surge in variant cases, lead to a slower pace of global growth momentum. Europe cannot reopen, China tightens credit policy faster than expected, and US households hold onto to excess savings amid lingering virus uncertainty. Diminished economic optimism leads to a pullback in global equity values and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.5%. The VIX rises to 25, the US dollar falls -2.5% and the fed funds rate stays at 0%. The inputs into the scenario analysis are shown in Chart 18 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 19. 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 scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 18Risk Factor Assumptions For The Scenario Analysis Chart 19US Treasury Yield Assumptions For The Scenario Analysis Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The model bond portfolio is expected to deliver an excess return over the next six months of +46bps in the base case and +54bps in the optimistic scenario, but is only projected to underperform by -27bps in the pessimistic scenario. Bottom Line: We are sticking with an overall below-benchmark portfolio duration stance, given accelerating global growth momentum, expanding vaccinations and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield given more stretched valuations in other credit sectors. On the margin, we are making the following changes to the portfolio allocations: downgrading both UK Gilts and UK investment grade corporates to neutral, while cutting the overall allocation to EM USD credit to neutral.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate 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 Please see BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Why Are UK Interest Rates Still So Low?", dated March 10, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. 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 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. 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 March 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 March 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 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 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. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance